Several companies think of growth but before that it is important to understand a term gross margin.
Investopedia defines gross margin as, “the number representing the proportion of each dollar of revenue that the company retains as gross profit after incurring the direct costs associated with producing the goods and services.”
For example, if a company’s gross margin for the most recent quarter were 35 percent, it would retain $0.35 from each dollar of revenue generated, to be used for paying off selling, general and administrative expenses, interest expenses and distributions to shareholders.
To analyze gross margin, you also need to analyze inventory investment as it helps to fund gross-margin growth. Here, the principle to be followed is that inventories should rise lesser than the sales growth rate of a company. An unanticipated spike in inventories occurs due to unplanned rise in inventory that may lead to cash-flow difficulties.
Let’s take the case study of a company with gross-margin dollars growing at a double digit rate, resulting in substantial earnings. The company had an increasing the credit line and hence difficulty in borrowing from the bank. The balance sheet analysis revealed that inventory investment had a higher growth rate than the company’s growth. In other words, the company was over investing in inventory. On further analysis, a significant portion of obsolete inventory was discovered. The problem also lied with the management as it had not been willing to take the required action to liquidate the stock, because of the negative impact on gross-margin dollars.
Eventually, the excess inventory issue created a cash flow issue and caused the company to borrow against its credit line. This, in turn, created more problems than if the firm had dealt with the obsolete inventory much earlier in the sales cycle and created additional cash flow.
This analysis gives us an insight into how management is deploying working capital and opportunities to reduce inventory and improve cash flow.