Definition: The gross margin ratio, also called the gross profit ratio, is a financial calculation that shows the profitability of a company’s main operations by comparing net sales with the costs associated with those revenues. In other words, it shows the gross margin as a percentage of net sales.
What Does Gross Margin Ratio Mean?
The gross margin ratio is calculated by dividing the different between net sales and cost of goods sold by net sales. By putting the gross margin calculation into a percentage format, management can analyze profitability trends year over year without regard to fluctuations in sales.
Let’s take a look at how the gross margin ratio is used by a retailer to analyze performance.
Most retailers and merchandisers pay very close attention to this financial ratio because it helps them analyze how well inventory is being purchased and sold. A higher cost of inventory will result in a lower margin. Conversely, a inflated sales figure with a stagnant cost will result in a higher margin for the period.
Management can also use this calculation to judge what types of products need to be purchased and sold more quickly. Compare merchandise with low and high price points for example. Expensive goods generally sell more slowly than cheap goods, but they also have a higher margin because retailers can mark up expensive goods much higher than cheaper goods. This means management can take more time to sell higher priced goods and still achieve the same profitability as selling lower priced goods faster.
This is an important concept for any retailer. High margin inventory can turn slowly while low margin inventory must turn several more times to make the same amount of profit.