Understanding Gross vs Net

When it comes to investing, evaluating the profitability of a company’s everyday sales is important to work out its financial strength. The most popular metrics are:

• Gross Profit Margin (GPM): This is the gross profit, divided by net sales, expressed as a percentage. For example, if a company’s gross profit was $300,000, and net sales (total sales less returns/refunds) was $500,000, then the GPM would be 60%.
• Net Profit Margin (NPM): This is the net profit after tax, divided by net sales, and is also expressed as a percentage. The net profit we now know comes from deducting all the costs from the net sales. The NPM gives us an indication of the profitability and sustainability of the business. For example, a 1% NPM suggests the margins are very low, and the company could easily make a loss. If an unexpected event occurred, the business might be in trouble. A higher NPM, such as 25%, suggests the company is highly profitable and has a robust business model. It is likely it has enough cash in the bank to be able to experience shocks or unexpected events and sustain profitability as the margins are high to take a temporary financial hit.

Applying GPM and NPM to a New Zealand company
Working through the example of a2 Milk’s recent financial results, it's clear the company has made a profit, but how does it compare to the previous year and is it less profitable or more profitable per sale?

In this example, the Gross Profit Margin is 57.2% (Gross margin $460,664,000/Total sales $804,946,000) which, as we will see below, is a strong result. You can compare it to the year before ($339,995,000/$610,629,000) which equates to 55.7%. Between the two periods, a2 Milk's gross margin has increased, meaning the business is more efficient at selling and/or producing its product.

When it comes to Net Profit Margin, we can see that Net Profit after tax is $184,926,000 and the company's sales were $804,946,000. The NPM is $184,926,000/$804,946,000, which equals 23%. This means that for every $1 of revenue a2 Milk makes, it makes 23 cents profit after tax. Comparing this to last year ($152,695,000/$610,629,000 = 25%), we can see the NPM has dropped as the company used to make 25 cents per $1. While total sales increased a lot ($810.9 million from $610.6m), the overall profitability fell.

Reasons why NPM can fall between years
Firstly, a2 Milk's GPM increased between period, which is positive. However, a fall in NPM can be caused by one or a number of reasons - higher staff costs, increased distribution costs, unexpected expenses etc. In the section below, we look at high and low NPM companies to see what can make a good (or bad) investment. 

To better explain the differences in NPM between well-known companies, we've picked those who have (historically) reported high NPM and low NPM.

1. Companies with historic HIGH NPM in New Zealand (click on the recent annual report to see our net profit margin calculation based on recent results)

• Fisher & Paykel Healthcare - NPM of 19.0% ($97.4m / $511.3m) in a recent annual report (source: Fisher & Paykel)
• a2 Milk - NPM of 23.0% ($184.926m / $804.946m) in a recent annual report (source: a2 Milk)
• Trade Me - NPM of 38.6% ($96.567m / $250.363m) in a recent annual report (source: Trade Me, now a private company)

2. Companies with historic LOW NPM in New Zealand (click on the recent annual report to see our net profit margin calculation based on recent results)

• The Warehouse - NPM of 2.2% ($67.443m / $3071.357m) in a recent annual report (source: The Warehouse Group)
• Air New Zealand (before COVID-19) - NPM of 3.3% ($101m / $3,015m) in a recent annual report (source: Air New Zealand)
• Burger Fuel - NPM of 5.7% ($1,183,373 / 20,899,915) in a recent annual report (source: Burger Fuel Worldwide)

The success of a business, in the long run, generally comes down to its product, the state of the industry and its control of costs. You can invest in a company that dominates the market, but if its technology is increasingly irrelevant and/or its costs are too high, it can see its share price fall to cents almost overnight. Examples include Kodak, Sky TV and Blockbuster (technology changes), Reader's Digest and Bauer Media (increased competition from internet publications and lack of advertising spend) and uncontrolled costs and too much debt (Virgin Australia, CBL Insurance and many New Zealand retail fashion brands).

We believe gross profit is a transparent way of calculating how viable the business is, while net profit shows the overall financial health of a business. When researching companies to invest in, be aware of the following:

• ​When companies make financial results announcements, they talk about net profit and compare it to the previous 12-month period. High-growth companies will often report revenue growth, rather than net profit growth, as they focus on increasing their market share. This is where analysing the gross profit margin is important to make sure the company is covering its costs of goods etc.
• Problematic companies report drops in revenue year after year, as well as shrinking net profits. Looking at the gross profit margin over a few years is often the most important tell-tale sign of the state of the company.
• Falling gross profit margins mean either the company can’t sell its product or service at a price that’s high enough to cover costs. This can start a dangerous spiral which causes the company to borrow money to meet its working capital obligations.

As useful as gross and net are for determining profitability, what matters is the balance sheet. Also known as the 'statement of financial position', it reveals how much cash the company has, its debt and its equity. Companies like a2 Milk have very little debt, whereas companies such as Fletcher Building and Fonterra have historically taken on a lot of debt. The cost of debt eats into profits and can restrict growth opportunities. Being debt-free gives a company more options and, in most cases, makes it an attractive investment opportunity. 

The video below, from Aussie Wealth Creation, helpfully explains why a balance sheet is essential for evaluating an investment opportunity. 

Beyond companies, gross and net are used in every day calculations for salaries and wages, as well as national economic measures such as GDP and GNP. We outline these below:

For a salaried employee or wage earner, gross income is the total wages or salary paid before deductions. I.e. if you earn $48,000 a year, $4,000 is your monthly gross income. After taxes, student loans and any other deductions like KiwiSaver contributions, you’re left with your net income. You can see how this works using our PAYE calculator. Gross income is what your employer pays, but net income is what the employee actually get to keep.

New Zealand media often talks about GDP - Gross Domestic Product. This is the total value of all goods and services produced in New Zealand in one year. This is different from NDP, or Net Domestic Product, which is GDP less the depreciation costs of all capital goods in the economy.