The gross margin ratio, also known as GMR, is a financial formula that calculates how much sales revenue is left after deducting the cost of goods (COGS) on all items sold. A simple gross margin ratio formula has two parts: Total Sales – COGS = Gross Profit; Gross Profit / Total Sales = GMR. This ratio is important because it lets companies know how much revenue they are generating through product sales to cover their selling and administration expenses. Accountants also use this ratio during their financial analysis process to determine how well a company has performed over time and how consistent it was in generating profits.
No single standard exists for determining how strong a company’s gross margin ratio is compared to the overall economic marketplace. The ratio is specific to each industry sector because companies must compare their ratios to companies with similar business structures. While any company may use gross margin ratio analysis, it is primarily used by manufacturers and retailers that use the ratio to figure out if they have priced their goods appropriately to recoup all business costs.
Because most companies want to operate at a profit, goods and services must be priced with a small margin of profit added to the cost. The gross margin ratio usually represents the additional amount of profit since the formula only includes the sales price and COGS of products and services. Gross margin ratio analysis is a small part of the overall financial ratio management analysis used to review a company’s financial information.
Financial ratio analysis is a popular management tool used to break down the financial statements presented to internal and external users. The popularity of this management tool is derived from the simple calculations traditionally used by accountants to determine how well a company operates from a financial standpoint. Ratio analysis is also used in tandem with benchmarking, which compares one company’s financial ratio calculations to a competitor’s ratio analysis. The company with the best ratio calculations usually represents the strongest competitor in the economic marketplace.
Gross margin ratio analysis should not be used as the sole financial ratio when reviewing a company’s financial information, however. Businesses are a sum of their total parts; while they may have a strong gross margin ratio, their expenses may be out of control or their overall sales may have been declining for the past several years. Companies must be broken down by all financial information reported in their financial statements to determine how strong they are in the economic marketplace.