Gross margin and net income are two of the most important financial measures for any business. They both provide insights into a company’s profitability, but they measure different things.
Gross margin is a measure of a company’s profitability before taking into account other expenses, such as taxes and interest. Net income, on the other hand, is a measure of a company’s profitability after taking into account all expenses.
So, which one is more important? That depends on your perspective. If you’re interested in a company’s bottom line, then net income is the more important measure. But if you’re interested in a company’s profitability before expenses are taken into account, then gross margin is the more important measure.
How is gross margin used?
By comparing a company’s business model to those of its competitors in the same industry, analysts can evaluate a company’s profitability and financial health using its gross margin. Although gross margin can give you a general idea of a company’s profitability, it is not a completely reliable indicator. Here are some examples of other ways to use gross margin besides determining profitability:
Assessing financial health
Since the gross profit margin reveals how well a company’s sales and production perform, metrics analysts can use it to assess the financial health of the organization. For instance, if the margin fluctuates significantly, this may indicate poor management techniques, inferior goods, or operational changes that may have temporarily increased volatility.
If a business decides to streamline its production, for instance, it might have a higher initial investment but a lower cost of goods because the newly streamlined operations will result in lower labor costs.
Gross margins could also change if the business changes the price of its goods or services. Let’s say a business increases the cost of its goods while keeping all other factors the same. When this happens, it results in a higher gross margin. But if the business charges too much, customers might decide not to buy their goods, which would mean lower profits.
Business model comparison
Analysts can compare different companies’ business models using gross profit margin.
As an illustration, suppose that Companies A and B both market the same item at a comparable level of quality. If Company A can produce the product for 1/4 of the cost, it will demand a higher gross profit margin because the cost of goods sold will be lower. As a result, Company A would have a competitive advantage over Company B.
However, Company B might choose to raise the price of its goods to help make up for the decline in gross margin and increase sales. Customers might decide not to buy Company B’s product at a higher price, which could result in Company B losing both market share and gross margin.
What is gross margin?
The gross margin, also known as “gross profit margin” or “gross margin ratio,” is a metric of profitability that displays the proportion of a company’s revenue that exceeds its cost of goods sold. In essence, a company’s gross profit margin demonstrates its ability to turn a profit despite incurring costs to produce its goods and services. The management team of a company is more effective at turning a profit for the expenses it incurs when the gross margin is higher.
While a company’s gross profit is defined as its net sales less its cost of goods sold, its gross profit margin is defined as its total revenue less its cost of goods sold, then divided by the total revenue. For example:
Net sales revenue minus cost of goods sold equals gross profit.
Gross profit margin is calculated by multiplying the ratio of net sales revenue by the cost of goods sold by 100.
Keep in mind that to express a company’s percentage of sales, you must multiply your calculation by 100 to obtain the gross profit margin. The gross profit, however, yields a precise dollar amount. In this equation, the term “cost of goods sold” refers to the cost of producing the goods and services that a business sells, and the term “net sales” denotes the gross sales excluding any discounts, allowances, or returns.
What is net income?
A company’s net income is its revenue less all of its expenses, including cost of goods sold, administrative costs, operating costs, interest, and taxes. In other words, it represents the sum of a company’s profits after deducting all of its costs. Businesses can use this extra cash to pay shareholders, settle debt, put money away for the future, or launch new ventures. Here is an example of how to calculate a business’s net income:
Net income equals total revenue minus cost of goods sold less expenses.
You can also use the formula below to calculate net income since the first part of the formula yields gross income:
Gross income – expenses = net income
For further simplicity, you can use the following calculation:
Total revenues – total expenses = net income
Remember that your net income could be negative or positive. If your company’s revenue is higher than its expenses, you will have a profit. When costs outweigh income, there is a loss on the balance.
Example of gross margin calculation
Consider that you run a company with net sales of $300,000. Your company’s cost of goods is $150,000 if manufacturing costs are $40,000 and labor costs are $110,000. To determine the gross profit margin, perform the following calculation:
Gross profit margin is calculated as [(Net Sales Revenue – Cost of Goods Sold) / (Net Sales Revenue)] x 100.
[($300,000 – $150,000) / ($300,000)] x 100 = 50%
Consequently, the company earned nothing for every dollar in sales. 50 in gross profit before deducting its other costs. Usually, businesses prefer high ratios because they mean that they will sell their inventory for a higher profit.
How is net income used?
Net income, the last line item on an organization’s income statement, represents the profitability of the business. It can also help companies that are publicly traded determine their earnings per share and investors make informed investment decisions. Here are some examples of how net income is applied:
Investment decisions
Investors use a company’s net income to gauge how much of its revenue exceeds its costs. Investors can decide whether the company represents a good investment opportunity based on this information. In essence, it enables shareholders and investors to assess the overall health of their investment.
For instance, if a company has a healthy net income, an investor might believe it is worthwhile to invest in the business. Investors using this information should make sure they’re looking at an accurate set of numbers that produced the taxable income and net income.
Calculating earnings per share
You need a company’s net income to determine its earnings per share. The resulting number helps indicate the companys overall profitability. The company is viewed as more profitable when its earnings per share are higher. You can use the earnings per share formula to understand how net income fits into this equation:
Net income less preferred dividends equals earnings per share (end-of-period outstanding common shares).
Investors can estimate the stock’s value by dividing the share price of a company by its earnings per share and calculating how much the market is willing to pay for each dollar of earnings.
Loan eligibility
To determine whether a company is eligible for a loan, banks look at its net income. It might provide a sizeable financial package, for instance, if it exhibits a reliable source of income. However, if the company’s net income doesn’t persuade the bank that it can make payments on time or that it is in good financial standing, it may have its application and eligibility denied.
Example of net income calculation
Consider the scenario where you want to calculate your company’s net income for the first quarter of the year using the data below:
This information allows you to determine that your expenses total $27,000.
You can now finish your calculation using the formula shown below:
Net income equals total revenue minus cost of goods sold less expenses.
$70,000 – $30,000 – $27,000 = $13,000
As a result, your company’s net income for the first quarter of the year was $13,000.
Gross margin vs. net income
While a company’s gross margin reveals the percentage of sales that exceed its cost of goods sold, its net income is calculated by subtracting all of its expenses from its total sales. The resultant figure is one of the biggest differences between these two measurements. While gross margin gives you a percentage, net income gives you a precise number.
Since both gross profit margin and net profit margin are expressed as percentages, they would make for a more accurate comparison. Remember that the terms net income and net profit are often used interchangeably because they have the same meaning. Net income doesn’t always equal profit, even though it does equal net profit. Here are some examples of how gross margin and net margin are different:
Consequently, despite the fact that both metrics are used to evaluate a company’s financial health, they differ significantly.
Profit Margin, Gross Margin, and Operating Margin – With Income Statements
FAQ
How do you calculate gross margin from net income?
The distinction is that net income includes all costs, including interest, taxes, depreciation, and other costs, whereas gross profit only accounts for direct costs.
