When reviewing a potential business investment, it's common for financial professionals to examine a company's gross margin and return on investment. Gross margin is a major predictor of return on investment — but these two terms aren't the same. Business managers and their investors alike should be able to easily differentiate between a return on investment and gross margin and harness their knowledge to help assess financial performance.
Return on Investment
Return on investment is the amount a given investment pays back, expressed as a percentage of the original investment. For example, an investment that returns $108 on an initial principal of $100 has an 8 percent return on investment, as $8 is the net return. Return on investment is usually used to assess the quality of a particular stock or bond, but managers sometimes use return on investment in reference to decisions, strategies and purchases made by the business.
Gross margin is a financial ratio that compares revenue and direct costs. "Income minus direct costs equals gross margin," according to Darren Dahl of "Inc." magazine. Gross margin is usually expressed as a percentage. Gross margin is closely associated with markup, and businesses with a healthy gross margin are significantly more likely to be profitable than those that are barely covering their costs. Gross margin doesn't include any indirect costs of sales — expenses such as rents, salaries and advertising — but it does include inventory and job-specific labor costs.
According to financial expert Jay Ebben, gross margin is an important predictor of return on investment, which is ultimately what owners and shareholders are looking for. This is because businesses with inadequate gross margins don't generate enough revenue to finance their operations. Gross margin is sometimes used to tip business managers off to potential problems with cost control or underpricing. Gross margin may often serve as a predictor of long-term potential return on investment. New businesses often have a negative or poor return on investment due to startup costs, but those that enjoy a substantial gross margin are much more likely to realize a profit if they survive their first few years.
Although gross margin is closely associated with return on investment, one doesn't always translate into the other. Businesses with significant indirect costs will still suffer a negative return on investment, even if they perform well in terms of gross margin. Additionally, changes in the market may affect a negative growth margin in the future so, as always, trends are important and past results aren't a guarantee of future returns.
- "Entrepreneur"; Return on Investment (ROI); 2011
- "Inc."; How to Track Your Company's Critical Numbers; Darren Dahl; 2010
- "Inc."; The Importance of Gross Margin; Jay Ebben; 2004
- "BPTrends"; Using ROI to Measure the Results of Business Process Improvement Initiatives; Gina Westcott; 2008
- "Inc."; How to Protect Your Margins in a Downturn; Darren Dahl; 2009
Matt Petryni has been writing since 2007. He was the environmental issues columnist at the "Oregon Daily Emerald" and has experience in environmental and land-use planning. Petryni holds a Bachelor of Science of planning, public policy and management from the University of Oregon.