Hey there welcome back to Accounting Stuff I'm James and today we're kicking off a new
series covering financial ratios these are the tools that help us analyze
financial statements first up Gross Profit Margin
What is Gross Profit Margin? Gross Profit Margin is Gross Profit
divided by Revenue it's a profitability ratio that measures a business's ability
to generate Gross Profit from each unit of Revenue earned
we often show it as a percentage so if that's the case then remember
to multiply by 100 Gross Profit is a business's Revenue
minus its direct Cost of Sales so here's another way to write the same equation
and keep in mind that Cost of Sales goes by a few different names
Cost of Services if a business sells services and Cost of Goods Sold if it sells products
anyway let's break this down so we can get a full understanding of how Gross Profit Margin works
we'll start with Profit you can find businesses Profit on its income statement
an Income Statement is a financial report that summarizes Revenue earned
and Expenses incurred over a period of time
Profit is the difference it's the financial gain generated
when Revenues are bigger than Expenses
alright so what about Profit Margin? Profit Margin is the ratio between Profit and Revenue
it shows us how much Profit a business generates for each dollar of Revenue earned
or when we times it by 100 what percentage of Revenue
it's able to convert into Profit for example here's the Income Statement
for a business called MAD they're a tech company that makes processors
and graphics cards out of California last year MAD earned one billion dollars in revenue
and they incurred 880 million dollars in Expenses the difference of 120 million dollars is their Profit
which is the financial gain to their business MAD's Profit Margin is 120 million dollars
divided by 1 billion dollars that's 12 cents of Profit generated on every dollar earned
a 12% Profit Margin if we multiply by a hundred now how does Gross Profit fit into all of this?
let's jump back to the Income Statement
this one's very compressed in reality businesses split out their Expenses
into a few different buckets first we take away the direct Cost of Sales
then all the indirect Operating Costs like research and development,
selling, general and administrative expenses, depreciation and amortization
and finally we subtract interest and tax expenses as you can see the Income Statement
shows three different types of Profit the big one at the top is called Gross Profit
the middle one is Operating Profit and the smallest one at the bottom is Net Profit
the bottom line so what is Gross Profit Margin?
at the start we said the Gross Profit Margin is a business's Gross Profit divided by its Revenue
it measures how much 'Big Profit' they're able to generate from each dollar of Revenue they earn
Gross Profit Margin only factors in a business's direct Cost of Sales
it totally ignores all of the indirect operating expenses, interest and tax
that we can see further down the Income Statement we use different ratios to measure those
which i'll explain in my next videos so remember to click subscribe if you'd like to see them
I've also put together a new cheat sheet which shows all the different profitability ratios
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example time what was MAD's Gross Profit Margin last year?
if we expand out their Income Statement we can see that they earned Revenue
of 1 billion dollars and they incurred 500 million dollars in Cost of Goods Sold
that left them with a gain in Gross Profit of 500 million dollars so their Gross Profit Margin is
500 million dollars in Gross Profit divided by one billion dollars in Revenue
that's 50 cents of Gross Profit generated on each dollar earned or 50% if we multiply by 100
but how should we interpret this? is 50% good or bad?
it's hard to say so let's make some comparisons first what was the year on year movement
in Gross Profit Margin? let's compare MAD's current and prior year Income Statements
we can see that they had a Gross Profit of 315 million dollars in the previous year
when we divide that by their Revenue of 700 million dollars that's a Gross Profit Margin
of 45% so MAD managed to raise their Gross Profit Margin by 5% year on year
that's good news because bigger is better they managed to generate five extra cents
of Gross Profit on each dollar they earned they also managed to increase their Revenue
from 700 million dollars to 1 billion dollars
things are looking promising but how does their Gross Profit Margin
compare against their competitors? here are the current year Income Statements
for MAD and INLET both of these businesses are in the same industry so it's fair
for us to compare their financial ratios INLET earned 7.8 billion dollars in Revenue
which is a lot more than MAD managed over the same period they incurred 2.34 billion dollars in Cost of Goods Sold
leaving them with a Gross Profit of 5.46 billion dollars that's a Gross Profit Margin of 70%
which is a lot higher than MAD's it seems like INLET is outperforming them
but let's make sure by checking out INLET's year on year Income Statement
we can see that their Gross Profit Margin actually decreased from 75% to 70%
hmm.. maybe things aren't as clear as they seemed what could cause a decrease in Gross Profit Margin?
Gross Profit Margin is Gross Profit divided by Revenue and we know that
Gross Profit is Revenue minus Cost of Sales so there are really only two ways that
Gross Profit Margin can go down either the sales prices are dropping
which could be down to discounting or a change in sales mix to lower margin products
or the Cost of Goods Sold are going up maybe there's been some supply issues with materials
or an unfavorable FX rate on foreign purchases perhaps direct labor costs have gone up
who knows! on the flip side an increase in Gross Profit Margin
could be caused by higher sales prices there could be a larger demand for the products or services
or a change in the sales mix to higher margin products alternatively Cost of Sales might have gone down
the business could have negotiated a discount with a supplier or switched to a cheaper one
they could have automated part of their production process or maybe they're experiencing some economies of scale
with financial ratios there's plenty to think about context is key
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if you'd like to see any other financial ratios have a good one!