Gross profit margin and net profit margin are two of the three common margin ratios derived from a company's income statement. The other is operating margin. While each metric is unique, they all help investors, analysts and managers assess the company's ability to turn revenue into profits.
Gross Margin Definition
Gross profit margin is the simplest and most basic margin calculation. It equals revenue minus cost of goods sold, divided by revenue. It shows how well the company gets good deals on purchases and turns them into high revenues. If the company generates $10,000 in revenue with COGS of $7,000, its gross profit is $3,000. Dividing $3,000 by $10,000, you get .3, or 30 percent for gross margin. Margins are expressed as a percentage.
Net Margin Definition
Net profit margin equals net income divided by revenue. Net income is the final calculation on the income statement after you subtract the COGS, operating expenses and other costs, such as interest and taxes. Using the previous example, a net income of $500 compared to $10,000 revenue would yield a net profit margin of 5 percent. The meaning of both margins depends on the context of the industry norms and comparisons to prior periods.
Gross Margin Interpretation
In his Inc. magazine article "The Importance of Gross Margin," Dr. Jay Ebben points out that gross margin is often overlooked and extremely important in determining the long-term viability of a business. A high gross margin helps you project the period of time before you break-even on your upfront investment and start to generate money. A small gross margin means you have to sell a lot of products to cover your overhead and earn profit.
Net Margin Interpretation
Net profit margin offers an ongoing picture of a company's ability to earn income, which is ultimately the goal. It is most useful when you compare the margin from one period to the next, according to VentureLine. If net margin is consistently diminishing over time, company leaders may need to take action to reduce costs or use marketing to generate more revenue. Without a reversal of falling net margins, the company may ultimately fail.
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