Gross margin is one of the most useful numbers that financial advisors can use to assess how well a business is performing. While net profit often gets more attention, gross margin is the first checkpoint in learning if a company is actually making money from its core activities.
If you want to help your clients evaluate whether a company has a sustainable, profitable business model, gross margin analysis is the essential starting point. In this article, Wealth Professional Canada will explore all that you need to know about gross margin. We'll discuss how to calculate it, what counts as a good gross margin, and the mistakes that can trip up even experienced financial advisors.
Gross margin is the percentage of revenue left after subtracting direct costs. These are the costs that go directly into producing or selling goods and services, such as labour and raw materials.
For manufacturing companies, direct costs are called cost of goods sold (COGS). In retail and wholesale, they’re known as cost of sales.
Gross margin is different from gross profit. Gross profit is the dollar amount left after direct costs are taken out of revenue. On the other hand, gross margin is this number expressed as a percentage of revenue. This percentage helps financial advisors compare performance over time and across different businesses.
If a company’s gross margin is negative, it’s a warning sign. This can mean that the business is spending more to produce goods or services than it earns in revenue. This is not sustainable and raises questions about the business model itself.
When conducting fundamental analysis, investors can look at gross margin to see if the business can manage costs and is likely to stay profitable in the future. It is a key factor when comparing companies and deciding if a stock is a good investment.
Gross margin is the first stage in analyzing a company’s financial performance. If a business has not achieved a positive gross margin, it means that they’re paying more to produce their goods or services than they are getting in revenue. This situation is not sustainable and is a big red flag for any investor.
For financial advisors evaluating investments, gross margin is a critical first-pass filter. A negative gross margin signals that a company is spending more to produce goods or services than it earns. This is unsustainable and indicates serious operational problems.
For your investment analysis, gross margin allows you to:
Gross margin analysis is the essential first step in determining whether a company deserves a place in your client's portfolio.
Calculating gross margin is straightforward. First, you need to find the gross profit. This is done by subtracting the cost of goods sold (COGS) or cost of sales from total revenue:
Once you have the gross profit, you calculate gross margin as a percentage of revenue:
Let’s look at a simple example. Imagine Company XYZ earned $800,000 in revenue last year, with a COGS sold totaling $500,000. The gross profit is $300,000 ($800,000 - $500,000). To calculate the gross margin, divide $300,000 by $800,000 and multiply by 100%. This gives a gross margin of 37.5 percent.
This percentage tells you how much of every dollar earned is left after paying for direct costs. The higher the gross margin, the more money is available to cover other expenses and invest in growth.
After calculating gross profit, you need to subtract other expenses to arrive at net income. These include:
Gross profit shows how much is left to cover these additional expenses. Companies with a positive gross margin have a good starting point for achieving a positive net income. If the gross margin is negative, it’s almost impossible to end up with a positive net income.
A 50 to 70 percent gross profit margin ratio might be considered good. Average gross margins can vary a lot depending on the industry and the usual expenses involved. Businesses with heavy labour or raw material costs tend to have lower gross margins.
On the other hand, industries with huge research and development (R&D) labour costs that are allocated to SG&A often have higher gross margins.
The key for financial advisors is to compare gross margin with similar companies. If the gross margin is above the benchmark, it might mean that the company is more efficient or has a stronger brand.
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When analyzing a company's gross margin, financial advisors should watch for common expense allocation issues that can distort the true picture:
Marketing, R&D, and administrative salaries are sometimes incorrectly categorized as COGS, which understates gross margin. This is particularly common in smaller companies or those with weak financial controls. When you spot this, it suggests the company lacks financial rigour – a risk factor for investors.
If a company changes how it categorizes expenses over time, historical comparisons become unreliable. Always check financial footnotes for any accounting changes that might explain gross margin trends.
Smaller businesses and early-stage companies often have less sophisticated accounting systems. Pay attention to expense allocation inconsistencies; they may indicate investment risk beyond just margin analysis.
Understanding these pitfalls helps you ask better questions when analyzing a company and spot potential financial statement issues before committing client capital.
Gross margin trends reveal important insights about a company's long-term investment appeal. A declining gross margin can signal competitive pressure, pricing weakness, or rising input costs – all negative indicators for shareholders.
Conversely, improving gross margin may indicate competitive advantages strengthening or operational efficiency gains. These trends often appear in gross margin before they show up in net income, making them valuable early warning signals for your portfolio management.
Here are some tips that you can apply to your practice:
These practices transform gross margin from a simple metric into a powerful diagnostic tool for assessing investment quality and managing risk for your clients.
Gross margin is a window into how well a business is turning its resources into real value. This measure provides a starting point for every important conversation about pricing, cost control, and long-term strategy.
When investors understand gross margin, they’ll be able to avoid mistakes that can cloud their judgment. Recognizing accurate expense allocation and making honest comparisons over time are all part of assessing whether a business can grow and thrive.
Gross margin highlights both strengths and weaknesses in a company’s business model. It isn’t just a number on a statement—it’s a foundation for helping your clients make solid investment decisions.
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