Analysing ratios is a critical part of the fundamental analysis of a company and its stocks. Net margin and gross margin belong to the domain of profitability ratios.

Each of these two metrics dispenses a specific aspect of an organisation’s profitability and cost-management efficiency. Therefore, it is essential to understand the key and subtle details in gross margin vs net margin to ensure a sound application of the said metrics.

What is Gross Margin?

Gross margin, also known as gross profit margin, is a profitability metric that shows the share of total revenue that a company reports as gross profit. Essentially, this ratio shows how much gross profit a business makes against Re.1 of its total revenue. For instance, when a company’s gross margin is 80%, it earns Rs.0.8 gross profit against Re.1 of its total earnings.

What is Net Margin?

It is also called net profit margin since the metric is derived from the net profit of an organisation. Both gross margin and net margin are based on the total revenue generated by a business. The net margin represents the percentage of total revenue a company reports as net profit.

A critical point in gross margin vs net margin is that the former is derived after only deducting the cost of goods sold (COGS) from total revenue. The latter, on the other hand, is computed after deducting all expenses and obligations from the total revenue. Resultantly, a company’s gross margin is always higher in comparison to its net margin.

How to Calculate Gross Margin?

In order to calculate gross margin, individuals need first to compute the gross profit. However, most companies list it out as a separate line item in their periodic income statements. Nevertheless, to calculate gross profit, the following items shall be subtracted from total revenue –

  • Raw materials consumed
  • Cost of labour
  • Production expenses
  • Inventory maintenance costs

Basically, all expenses directly related to the core operations of a business are regarded as gross margin. It is a critical point of difference between gross margin and net margin.

After the calculation of gross profit, its ratio can be calculated using the following formula –

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Gross margin = (Gross profit / Total revenue) x 100

How to Calculate Net Margin?

Individuals need to calculate the net profit before deriving the net margin. However, similar to gross profit, net income is also a separate line item in a company’s typical income statement.

The items deducted from the total revenue to calculate net income are –

  • Cost of revenue
  • Depreciation
  • Administrative overhead
  • Interest on debt
  • Tax
  • Outflows of cash belonging to that specific period per accounting standards

Net profit can also be calculated from gross profit by deducting every item mentioned above to save the cost of goods sold. It is critical when considering the difference between gross and net margin.

Nevertheless, net margin can be derived using the following formula:

Net margin = (Net income / Total revenue) x 100

Note: Total revenue can be listed as total net sales in specific income statements. In that case, it is calculated after adjusting total sales against discounts, allowances, etc.

Example of Gross Margin vs Net Margin Calculation

Illustration 1:

The following table illustrates the income statement of ABS Ltd. for the Financial Year 2018 – 19.

Total revenueRs.5 lakh
Raw materialsRs.25000
Miscellaneous expensesRs.10000

Here, Gross profit = Total revenue – (Raw materials + Wages) = Rs. {500000 – (25000 + 15000)} = Rs.460000.

Therefore, Gross margin = (Gross profit / Total revenue) x 100 = (460000 / 500000) x 100 = 92%

Now, Net Profit = Gross profit – (Salary + Interest + Miscellaneous expenses + Tax) = Rs. {460000 – (80000 + 10000 + 10000 + 10000)} = Rs.350000

Ergo, Net margin = (Net profit / Total revenue) x 100 = (350000 / 500000) x 100 = 70%

Thus, in this case, gross margin vs net margin is 92% and 70% respectively.

Illustration 2:

The following table shows an excerpt from the income statement of Reliance Jio for FY 2019 – 20.

ParticularsAmount (in Crore)
Total revenueRs.350519
Cost of revenueRs.244711
Gross ProfitRs.105808
Administrative expensesRs.33347
Personal expensesRs.6067
Depreciation and amortisationRs.9728
Net incomeRs.35148

Here, Gross margin = (105808 / 350519) x 100 = 30.19%

And, Net margin = (351548 / 350519) x 100 = 10.02%

In this case, the difference between gross and net margin is 20.17%.

How to interpret Gross Margin and Net Margin?

Both gross and net margins are critical indicators of a business’s profitability and competency in cost management.

As gross margin denotes the relationship between core operational costs and total revenue in a roundabout manner, it helps companies assess how well it is managing costs against Re.1 of revenue.

As a critical pointer to gross vs net margin, the latter denotes the relationship between the total costs a company incurs against its entire revenue. Ipso facto, net margin offers a more definitive understanding of an organisation’s cost management efficiency.

Furthermore, by that virtue, both gross margin and net margin can be used as a metric for comparison between companies with varying scales of market capitalisation within the same industry. Using gross margin in conjunction with net margin provides an understanding of how efficiently companies are containing the costs and obligations not directly related to production.

One limitation that both these metrics share is that they cannot be used for comparing companies belonging to different industries because the average varies. Furthermore, merely engaging in gross margin vs net margin does not suffice a robust financial analysis.

Therefore, individuals might also utilise operating margin along with net margin and gross margin to understand a company’s credit leverage.