Also a profitability ratio, the gross margin ratio compares a business’ gross margin to its net sales, measuring if a company sells its merchandise or inventory in a way that would bring it profit.
Basically, the gross margin ratio – or gross profit ratio – makes the difference between the cost of merchandise and the profit it is able to gain for the company. This profit, which comes straight from the sale of inventory, can be used to pay off a company’s operating expenses.
The Basics of Gross Margin Ratio
Not to be confused with profit margin ratio, the gross margin ratio takes into account only the cost of the goods that have been sold, as its main purpose is to measure the profitability of selling merchandise and/ or inventory. For example, the profit margin ratio we mentioned takes into account other expenses as well, while the gross margin ratio does not.
Naturally, higher ratios are the ones the companies are after. With a higher gross margin ratio, the management of a company is sure that their business is selling its inventory at a higher profit percentage. There are two ways through which a company/ business can have a high gross margin ratio. First of all, a company can buy its inventory quite cheap – especially when buying from the wholesaler or manufacturer, as they can grant their buyers a purchase discount.
Basically, if the cost of inventory is low, then the gross margin ratio will have a higher rating. Of course, the other way companies can rely on to have a high gross margin ratio is to mark their goods up higher. However, this has to be done carefully, as the company/ business might lose customers if the prices are too high.
The Formula of Gross Margin Ratio
When measuring the gross margin ratio, one has to divide the gross margin of a company by its net sales – easy, right?
Indeed, the formula is just as easy as it can get. It basically subtracts the cost of goods, either inventory or merchandise, from the net sales.
Of course, when measuring the net sales of a company, one has to take into account any returns of refunds. In case there have been any then they will have to be taken out from the gross sales – this will round up the company’s correct net sales.
Final Thoughts
A high gross margin ratio can help a company in many different ways. This ratio is basically the company’s profit, which can be used to fuel any other of its parts.
For example, rent, utilities, salaries, and other operating expenses will be paid off more efficiently, as the company will have more money to do so.
Moreover, as the gross margin ratio is also used to measure the profit that comes from selling inventory, the percentage of sales that can eventually be used to support and fund other parts of the company/ business is also measured.
Therefore, a higher gross margin ratio comes with benefits for the entire company or business.