Income Statement Insight: Gross Margins Matter

How Gross Margins Affect a Company

Like any other fundamental metric, investors should be interested in gross margins to help get an idea about a company's overall financial health and current performance. Gross margins play an essential role in helping predict a company's future performance because they have such a major influence on a company's bottom line (see profit ).

Simply put, when it comes to gross margins, bigger is better -- the market likes companies that make comparatively more money on each unit (of whatever their product or service is) they sell. And gross margins are invariably tied to a company's break-even point: In order to compensate for fixed elements of COGS, products with lower margins need to be sold at a higher volume than those with higher margins.

So if you're investing in a company that targets a smaller market, you should see higher margins on their products. This is a market concept that can be seen in the book industry: While it likely costs approximately the same amount of money to produce a mass-market hardcover book as it does a college textbook, the textbook has a smaller base of potential customers, so it's marked up a whole lot more.

How Gross Margins Affect You

If gross margins can affect a company's bottom line, they can certainly affect your bottom line (see return ). On the stock market side, movement in a company's gross margins can translate to movement in its share price . How? If a company is losing profitability (falling gross margins), it will look less attractive to investors, and the share price will suffer. Conversely, increasing margins can lead to an increase in share price (see earnings per share ).