How Gross Margin Affects a Balance Sheet

Gross margin, an income statement derivative, affects a company's balance sheet through the customer receivables and inventory accounts. "Income statement derivative" means financial analysts use data from a statement of profit and loss -- the other name for an income statement -- to calculate gross margin. Customer receivables represent money a company expects from clients.

Gross Margin

To calculate gross margin, compute gross income, divide gross income by total sales and multiply that result by 100. Gross income equals total sales revenue minus merchandise expense, also known as cost of goods sold. For example, assume a company's periodic performance data shows the following: sales revenue, $1 million; cost of goods sold, $750,000; and gross income, $250,000, or $1 million minus $750,000. As a result, the organization's gross margin during the period under review equals 25 percent, or $250,000 divided by $1 million multiplied by 100.

Relevance

As a key profitability ratio, gross margin indicates to investors and market observers whether a company is adept at managing its material costs or whether it's struggling to find its commercial voice. A lower gross margin might signal that corporate leadership is finding it difficult not only to craft a sales strategy that works, but also to find vendors and suppliers eager to deliver raw materials at prices that are sensible from a profitability standpoint. A higher gross margin means department heads are doing a good job reining in waste, setting prices at levels that seem reasonable to customers, and running efficient and profitable operations.

Balance Sheet

Financiers review a company's balance sheet to see how well an organization is grappling with a bad economy or how adeptly it's solving its "assets vs. debts" equation. The last analytical item is a staple in balance sheet management because assets, debts and equity items flow directly into a statement of financial position, the other name for a balance sheet. Assets consist of everything -- from cash to equipment and intellectual property -- a company uses to operate. Debts represent loans it must repay. Equity is money investors put into corporate activities, as well as the organization's own cash -- what accountants call "retained earnings."

Relationship

Gross margin calculation draws on sales and merchandise data analysis. To record sales, a corporate bookkeeper debits the customer receivables account and credits the sales revenue account. The bookkeeper also triggers a numerical dent in the merchandise account by crediting the inventory account and debiting the "cost of goods sold" account. Customer receivables and inventory are balance sheet accounts, so decreases in their amounts negatively affect balance sheet data.