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Gross margin and net margin are key profitability ratios for measuring a company’s profits against the revenue over a period of time. Both gross profit margin and net margin are expressed in the form of percentage and measure profitability compared to the revenue for a set period. Furthermore, these ratios provide a glance at the company’s wellbeing.

Analysing ratios is a critical part of fundamental analysis of a company and its stocks. Each of these two metrics dispenses a specific aspect of an organization’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 the comparison 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 margin 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 gross margin vs net profit.

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 & Net Margin Calculation

Illustration 1:

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

Particulars Amount 
Total revenue Rs.5 lakh
Raw materials Rs.25000
Wages Rs.15000
Salary Rs.80000
Interest Rs.10000
Miscellaneous expenses Rs.10000
Tax Rs.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, the gross profit margin and net profit 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.

Particulars Amount (in Crore)
Total revenue Rs.350519
Cost of revenue Rs.244711
Gross Profit Rs.105808
Administrative expenses Rs.33347
Personal expenses Rs.6067
Depreciation and amortisation Rs.9728
Interest Rs.12105
Tax Rs.9413
Net income Rs.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.

Limitation of Gross and Net Margin

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 the comparison of both the margins 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.

Gross margin and Net Margin – FAQs

Ques. Why you should track gross margin and net margin?

Ans. Gross margin and net margin provide a lot of information about your company’s current profitability and position in the market.

These metrics should be checked to evaluate the growth of any business. For example, a small scale startup can have a low and unstable margin percentage and should be considered as normal as it takes some time to build and run an efficient operation.

Therefore, these metrics are essential to examine as a whole to get a clear picture of the growth of your business.

Ques. What can be considered as a good net profit percentage?

Ans. A good margin differs significantly depending on the industry and size of the business, but generally, a net profit margin of 10% is considered average and a 20% margin is considered high (or “good”), and a 5% margin is considered as low.

Ques. Is a high net profit margin good?

Ans. A high net profit margin shows that a business is selling its products at the correct price and is implementing good cost control. Generally, a net profit margin above 10% is considered excellent; however, it entirely depends on the industry and the business structure.

Ques. What does a high net profit margin indicate?

Ans. The higher is the net profit margin, the more money a company is supposed to keep.

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