Gross margin ratio: formula, calculations, and what it tells you

How do investors determine which companies are worth investing in? While many intangible factors contribute to a business’s success, experienced investors examine the metrics that give insight into a company’s financial health.

One of these critical metrics is the gross margin ratio. Since it provides clues about profitability, operational efficiency, and cost management, it can be a good all-around tool for evaluating a company’s performance.

To improve your financial literacy, you need to understand what the gross margin ratio can tell you about a company’s profitability and growth potential. Keep reading to learn how to calculate it and how you can use it as an investment tool.

What is the gross margin ratio, and how does it work?

Suppose a shoe company wants to know how much it makes in sales compared to its production costs. Calculating this figure would give you a gross margin ratio. Also called the gross profit margin ratio or GP margin ratio, it highlights how efficiently a company produces its goods or services relative to its sales.

If a company has a high GP margin ratio, its sales revenue is high compared to production costs. The higher the gross profit margin ratio is, the better. However, the ideal ratio varies and is typically lower in industries like retail, which has high production costs compared to service industries.

If the GP margin is low, a business might need to find ways to cut production costs or increase prices. However, raising prices could have other effects, like a weakened market position if fewer customers can afford to buy costlier products.

Maintaining a healthy gross margin ratio requires companies to balance production costs and sales revenue to keep their business profitable and efficient.

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FAQ: What is an ideal gross margin ratio?

One recent study found that the average gross profit margin ratio across all industries is 36.56%. But this doesn’t mean every business should aim for this number.

While higher gross margin ratios are better than lower ones, generally speaking, there’s no exact number for the perfect gross margin ratio. The ideal ratio depends on the specific industry and business strategies. 

Gross profit margin ratio vs. net profit margin

Both metrics are key indicators of a company’s financial health, but they have different focus areas.

• Gross profit margin looks at sales revenue compared to production expenses only, focusing on production efficiency.

• Net profit margin subtracts production expenses from revenue and accounts for operating expenses, interest, taxes, and other expenses. As a result, it provides a more comprehensive picture of overall profitability.

The formula: How to calculate gross margin ratio

FAQ: How do you calculate gross margin ratio?

1. Figure out the total sales revenue.

2. Calculate the cost of goods sold (COGS).

3. Subtract COGS from the total sales revenue. This will give you the gross profit.

4. Divide the gross profit by total revenue, then multiply by 100 to get a percentage value. This is the gross profit margin ratio.

Gross margin ratio formula

Gross margin ratio = (total revenue — COGS/total revenue) × 100

Example calculation

Suppose you run a clothing company and want to find your gross margin ratio to see how you can improve profitability. The first year, your total revenue was $200,000, while your COGS was $120,000.

First, you'll find your gross profit by subtracting COGS ($120,000) from total revenue ($200,000). This gives you a gross profit of $80,000.

Then, you'll divide gross profit ($80,000) by total revenue ($120,000) and multiply it by 100. This leaves a gross margin ratio of 40%.

Applying gross margin ratio in investment analysis

Investors care about the gross margin ratio because it reflects a company’s ability to generate profit from its primary operations. But it doesn’t give a complete picture of financial health on its own.

For instance, you can't compare a fast-food chain’s margin with a national bank’s. The restaurant industry has high production costs and low sales prices compared to the banking industry’s high-value services. Understanding how a specific industry functions is key to interpreting gross margin ratio numbers in a way that’s useful for investors.

Gross margin ratio as an investment tool

Gross margin ratio is just one of many metrics investors use to evaluate whether a company is likely a good investment opportunity.

If a company's gross margin ratio is stable or improving, it could show investors that the company is being efficiently managed and can make money moving forward. Alternatively, declining GP margins could indicate issues with management or pricing strategies that need improvement.

Comparing gross margin ratios across industries

Here’s how the average gross margin ratio compares across 10 different industries, according to the latest NYU data from 2024:

• Advertising: 28.11%

• Apparel: 51.93%

• Auto and Truck: 12.45%

• Banks: 100%

• Business and Consumer Services: 33.5%

• Entertainment: 38.09%

• Pharmaceutical Drugs: 65.26%

• Renewable Energy: 61.67%

• Retail (General): 30.86%

• Software Systems and Applications: 71.52%

Typical gross margin ratios vary widely across different industries. It’s important to know the industry standards or work with an experienced investor before using the ratio to inform any investment decisions or strategies.

Using gross profit margin to learn financial fundamentals

Knowing what gross profit margin means and how it helps determine business profitability is helpful as you prepare to invest in actual companies. Before investing, it’s crucial to do your homework and develop practical investment strategies that will help you maximize your return on investment.

Understanding gross profit margin helps you:

• Better understand business performance

• Compare companies

• Understand differences in industry standards

• Analyze trends over time

• Grasp the relationship between risk and reward

• Get a better idea of how companies are valued

Level up your financial knowledge and learn more concepts like gross profit margin by playing our financial literacy game aimed at teens and families, and use this knowledge to start building important habits that will help you save money and build wealth.

Explore the Greenlight® Learning Center for more tips and guides. You can also download our app today to learn more about investing!

Disclaimer: Greenlight is a financial technology company, not a bank. The Greenlight app facilitates banking services through Community Federal Savings Bank (CFSB), Member FDIC.