Knowing your way around an income statement will help you considerably when researching stocks. You will be able to determine the earnings power of the company and figure out the key drivers of the results. It is also important to analyze margins, because they may provide hints about the competitive position of the company. One of the key margin metrics is gross margin percent, but for some companies, especially those with high inventory carrying costs, adjusted gross margin percent may be a more useful figure.
Gross margin is the income the company makes on the sale of a good or service after subtracting only the direct costs of labor and materials for the inventory. Other expenses, such as research and development, marketing, interest, selling, general and administrative (SG&A), are not included in the calculation. If the company sold a widget during the year for $100 and it cost $60 to make the widget and the company paid the CEO $20, the gross margin would be just $40.
Gross Margin Percent
Gross margin percent is the key number to consider to detect trends in a company's results. Gross margin percent is gross margin divided by sales revenue. It reveals two key pieces of information: the company's pricing power and cost pressures. If gross margin percent is contracting, the market may be getting more competitive and/or the cost pressures are beginning to pick up. All else being equal, you want gross margin percent as high as possible and trending higher. That leave more income for the shareholders.
Adjusted Gross Margin Percent
For companies that have a lot of inventory or high inventory costs, the adjusted gross margin percent is a more representative metric, because inventory carrying costs are not accounted for in inventory. Carrying costs would be inventory insurance and all other costs associated with storing the inventory. Once an analyst adds carrying costs to the inventory costs and subtracts that figure from sales revenue, the adjusted gross margin percent may dip significantly. This provides a more accurate calculation of the profitability of the company's products.
Other Analytical Tools
An analyst has a number of tools in the toolbox that he can use. Other useful tools include valuation tools such as price per earnings, price per sales, price per cash flow, return on assets and other ratios that measure the price of a share relative to the firm's earnings. Combining those tools with gross margin percent and adjusted gross margin percent will give you a better overall picture of the investment opportunity. Also, you should compare the gross margin percent and adjusted gross margin percent from year to year to determine the trend of the company -- that is, whether its gross and adjusted margin percent seem to be increasing or decreasing.
Alex Shadunsky has a bachelor's degree in finance and is pursuing a Master of Business Administration from Indiana University. He has worked at Briefing.com as a junior equity analyst specializing in health-care stocks.