Your money: what gross profit margin says about a business

Investors must make deductions from the gross profit margin (GPM) of target companies for the investment. Here’s how they can do it:

Income statement
This is one of three statements publicly disclosed by a limited company in accordance with GAAP requirements. Companies regularly publish their quarterly and annual income statements. Let’s look at the gross profit margin calculation and its uses. Suppose there is a company called Wesely Lakshay Ltd (WLL). WLL’s data for the quarter ending December 31, 2020 is (in Rs crore): 800; cost of material consumed 200; purchase of shares in commerce 20; change in stocks of FG & WIP (10); social charges 50; financial charges 5; depreciation expense 12; other expenditure 160 and total expenditure 437.

Gross profit margin (GPM)
It is calculated by dividing a company’s gross profit by its operating income for a given period. Gross profit is calculated by subtracting the cost of goods sold (CGS) from the operating income of a business during a given period. Although operating income can be chosen from the income statement, the CGS figure is not explicitly stated.

Cost of Goods Sold (CGS)
The CGS reveals the cost of manufacturing / marketing the part of the goods sold. Therefore, we can think of CGS as the sum of the cost of materials consumed, the purchase of trade shares, changes in FG and WIP inventory, payroll taxes, and depreciation. We can exclude other expenses in the calculation because it is usually the sum of all expenses incurred in the sales, general and administrative functions of the companies. We ignore the financial costs in CGS head when it comes to corporate financial expenses.

CGS for WLL for the quarter ending December 31, 2020 = 200 + 20-10 + 50 + 12 = Rs 272 crore. And suppose the CGS for WLL for the quarter ending September 30, 2020 is Rs 350 crore.

The GPM for WLL for the quarter ending December 31, 2020 = (800-272) / 800 * 100 = 66%. and GPM for WLL for the quarter ending September 30, 2020 if its operating income is Rs 900 crore = (900-350) / 900 * 100 = 61%. This indicates that the company has improved its GPM such that its gross margin is Rs 66 for every Rs 100 of operating income during the current quarter, and that it is increasing by Rs 5 during the quarter in course compared to the previous one. MDM should be used for manufacturing and trading companies as CGS is a major expense for them. A company can be compared either on its own historical MDMs, or on the comparison with that of its peers. The higher the GPM, the better a company’s efficiency in managing its production / merchandising expenses.

The writer is associate professor of finance at XLRI-Xavier School of Management, Jamshedpur