There are three financial statements that are used to analyze a business's efficiency. The balance sheet, cash flow statement and profit and loss statement -- also called an income statement -- are tools that give the analyst the big picture. The income statement reveals the business's revenues and expenses over a reporting period, such as a month, quarter or year. Simple income statement calculations show how much revenue a business keeps as profit.
Gross Profit Margin
The gross profit margin measures how much revenue is left over after sales costs are subtracted; the result is divided by total revenue. Higher margins are better and indicate that the business is operating efficiently. If expenses are a significant portion of revenue, resulting in a low gross profit margin, it can mean two things. Either the business is not operating efficiently, or the business is by nature a low margin business. Low margin businesses depend on sales volume to make profits. Examples of low margin businesses are retail clothing and electronics stores.
Net Profit Margin
Net profit margin is calculated by subtracting all of the business's expenses from revenue, versus only subtracting the cost of goods sold; this means that overhead costs, like administrative expenses, building expenses and income taxes are included. Again, higher margins are better. When a business has a low net profit margin, it means that it spends a large portion of its revenue to maintain its total operation. A low net profit margin may mean that the business spends a large amount of money on cost of good sold (COGS), overhead or both.
Comparing Gross Versus Net Profit Margins
Analyzing why a company has a low net profit margin is essential to understanding its efficiency. If a company has a high gross profit margin, then its core business is probably operating efficiently -- this is always the goal. If the net margin is low, it may mean that the company is spending too much on overhead costs which don't directly contribute to the quality of the product. When this occurs, a business may try to cut back on overhead costs through a reduction in spending. Alternatively, it may try to figure out how to increase revenue without increasing net expenses proportionally.
How Much Is Good
The size of the company will directly affect its margin. Generally, smaller companies should operate more efficiently, because there are less expenses. As the size of the company increases, margins often decrease because of increased overhead. Large companies should have a gross margin of at least 35 percent, according to Teenvestor.com, while medium-sized companies should have a gross margin of over 50 percent. There are exceptions; if a company has an exciting new product or patent that is generating buzz, then it may present an up-and-coming investment opportunity. Keep in mind that as revenues increase, so does the cost of doing business -- which may result in lower gross and net margins.
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