Income Statement Insight: Gross Margins Matter

Gross margins increased... Gross margins fell... Gross margins were light... At one point or another -- especially during earnings season -- you have probably read or heard about a company's gross margins. But why?

Understanding a company's gross margins is a big part of fundamental stock analysis , as it's directly related to just how well a company is able to make a profit, and can have a big influence on its stock price.

What Are Gross Margins?

Simply put, gross margins are the revenues a company has left over after the cost of production. A gross margin comes from a company's income statement -- it's the difference between revenues and cost of goods sold (COGS, also referred to as cost of revenue), which can be either a dollar number (gross profit) or a percentage. Gross margins are essentially a measure of profitability.

Let's say that you own a company that produces umbrellas. Each umbrella costs $5 to make and is sold for $10. So the gross profit on an umbrella is $5. But what is the gross margin on that umbrella? 50%. How? Revenue ($10) less cost of revenue ($5) divided by revenue ($10) multiplied by 100. And while this number is vastly useful for investors, it's important to remember that there are some items that come in between the gross profit and net income.

Things such as "selling, general and administrative" expenses can have a huge impact on the bottom line of a company with an otherwise awesome gross margin. So why is the gross margin such an oft-touted fundamental metric?