Technicals Stability Returns

## Understanding Gross Margin

The Gross Margin ratio is the difference between revenue and the cost of goods sold (COGS) divided by the total revenue, and it is expressed as a percentage. This profitability metric is used to determine the value of incremental sales. And it indicates how much profit the company is making after paying off its cost of goods sold (COGS) and how it generates revenue from its costs that are directly tied to production. The Gross Margin ratio is also known as the Gross Profit Margin. A high Gross Margin ratio is considered more favorable.

The formula to derive Gross Margin

Total Revenue - It indicate revenue from selling goods and services before deducting any expenses. Total revenue is found in the company's Income Statement.

Cost of Goods Sold - COGS is the direct cost of producing the goods or inventories sold by the company. It includes the costs such as the cost of raw materials, direct labor costs, etc.

Example of Gross Margin: For the financial year, Tata Steel Ltd. reported Cost of Goods Sold (COGS) as Rs. 83478.74 Cr., and Total Revenue as Rs. 242326.87 Cr.
The value as per the formula (Total Revenue - Cost of Goods Sold / Total Revenue) is calculated as (83478.74 / 242326.87) = 65.55

##### Key Highlights

Gross Margin also indicates each rupee of revenue earned that the company retains after subtracting COGS.

For most industries, the ideal Gross Margin ratio ranges between 50% to 60%.

When the cost of production surpasses total sales, then gross margin can become negative.

##### Gross Margin is an independent metric, but while looking at Gross Margin, the following points should also be taken into consideration:

For most industries, the ideal Gross Margin ratio ranges between 50% to 60%. It changes from industry to industry. A low margin ratio for a particular company indicates that the company is inefficient in managing its cost of goods sold. But in some cases, a low margin for a particular company does not show it has poor performance. Investors must look at other factors.

Gross Margin also indicates each rupee of revenue earned that the company retains after subtracting COGS.

From margin ratios, gross margin is the first to be calculated. After the gross margin ratio, other margin ratios are calculated, such as Operating Margin, EBITDA Margin, PAT Margin, and lastly, Net Margin.

Always compare companies from the same industry, because the ideal range of gross margin changes as per every industry. Some industries need low production costs, like technology, compared to capital-intensive industries.

When the cost of production surpasses total sales, then gross margin can become negative.

Gross margins neglect the impact of tax, depreciation, and operating expenses. Therefore, we cannot rely on single metrics.

##### How to Use Gross Margin Effectively

Investors should look at companies with a high Gross Margin.

Always compare companies within the same industry as the gross margin changes from one industry to another. Capital-intensive industries like automobiles are likely to have a low gross margin compared to the IT industry. Capital-intensive companies have a huge expense that comes with production.

We cannot rely on a single metric to analyse any company. With gross margin and other margin ratios, analysts can also look at Asset Turnover Ratio, Inventory Turnover Ratio, EPS, etc.

##### Negative Gross Margin & Sudden Fall in Gross Margin

The gross margin of the company turns negative when the cost of production exceeds the total sales. A negative gross margin indicates that the company is not efficient in controlling its costs. Or it can be due to natural consequences like macroeconomic difficulties or industry-wide difficulties that are beyond the control of the company's management.

Also, a sudden fall in sales can lead to a sudden fall or negative Gross Margin even if the COGS remain the same. And poor pricing of the product could lead to lower than expected profit and ultimately lead to a loss.

An increase in the cost of raw materials can wipe out profits and lead to a loss. For example, if the company has already signed a contract to deliver its product to a customer and the price of raw materials increased after the contract, exceeding the price of the product would lead to negative gross margin. Or, labour costs rise faster than expected COGS. For example, if a company has a large order and less time to finish production, then the company might have to pay an employee for extra work or may need to hire additional help to complete that order.

Macroeconomic factors like a recession can reduce profits for companies as consumers reduce spending and businesses scale back operations.

##### How to Interpret Negative Gross Margin

While interpreting negative gross margin, always compare companies within the industry and also look at the past performance. A negative gross margin could lead anyone to believe that the company's management is inefficient in managing its costs or has made mistakes in decision-making.

Any company can experience a loss in the short term, even if it is an established player in the market.

#### Range Indicator of Net margin Ratio

Above 100 Strong Bullish Extremely High Margin
80 to 100 Bullish High Margin
60 to 80 Mild Bullish Good Margin
50 to 60 Neutral Average Margin
40 to 50 Mild Bearish Low Margin
30 to 40 Bearish Very Low Margin
Below 30 Strong Bearish Extremely Low Margin

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