Another Gross Margin Calculation You Need To Know

 
 
gross-margin-calculationIn our last column we discussed the importance of Gross Margin on the overall profit performance of a company

But for some companies such as retailers, manufacturers and distributors that have and manage inventory, a major part of looking at Gross Margin is the need to focus on the inventory investment that is needed to fund gross margin dollar growth.

An important principle is that inventories should rise less than the sales growth rate of a company.

Companies that have an unplanned significant rise in inventory may be setting the stage for impending cash flow difficulties.

A recent client experience brings to light the consequence of a company that fails to manage its inventory investment. In our client’s situation, gross margin dollars were growing at a high teen double digit growth rate over last year.  This resulted in substantial earnings growth that everyone was cheering about.   The company, however, was constantly bumping up against its credit line and was running out of the capacity to borrow from its bank.

An analysis of the balance sheet revealed that the inventory investment was growing significantly faster than their growth in gross margin dollars.  With average inventory growing 40% over the previous year, the company was literally over investing in inventory relative to the return in gross margin dollars.

An important principle is that inventories should rise less than the sales growth rate of a company.

We also discovered that a significant segment of inventory was obsolete …

We also discovered that a significant segment of inventory was obsolete.  Management had not been willing to take the appropriate action to liquidate and turn it into cash as it would have had a negative impact of gross margin dollars.  The end result of this is that the excess inventory created a cash flow issue that ultimately forced the company to additionally borrow against its credit line.  This in turn created more problems than if they would have dealt with the obsolete inventory much earlier in the sales cycle and created additional cash flow.

We often use a measurement called GMROI, or Gross Margin Return on Inventory

This gives us an insight into how management is deploying working capital and opportunities to reduce inventory and improve cash flow.

Investopedia defines GMROI as:  An inventory profitability evaluation ratio that analyzes a company’s ability to turn inventory into cash above the cost of the inventory. It is calculated by dividing the gross margin by the average inventory cost and is used often in a number of industries.

 

To illustrate:

                                    GMROI =       Gross Margin $
                                                      Average Cost Inventory $

 

This is a useful measure as it helps the investor, or management, see the average amount that the inventory returns above its cost. A ratio higher than 1 means the firm is selling the merchandise for more than what it costs the company to acquire it. The opposite is true for a ratio below 1.

GMROI is an important measurement to evaluate a company’s efficient use of its inventory investment.  It can also be used to evaluate segments of its inventory such as product lines or product categories.  GMROI standards can be different by industry and it is important to understand how your company’s performance compares to the industry average. 

 The importance of managing inventory investment is a significant factor in improving cash flow and profitability of companies of all sizes.   It is critically important for middle market companies that have working capital challenges and require additional funding to operate the business.