Obsessed About Revenue? Don't Forget to Check Gross Margin

So many middle market companies focus on growth. That's not a bad thing at all. But they also need to understand a term called 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."

Related: How to Calculate Gross Profit

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 put toward paying off selling, general and administrative expenses, interest expenses and distributions to shareholders.

When you're looking at gross margin you also need to analyze the inventory investment that's required to fund gross-margin dollar growth.

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

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

Let's talk about a company we know: Gross-margin dollars were growing at a high-teen double-digit growth rate. This resulted in substantial earnings growth that everyone was cheering about. The company, however, was constantly bumping up against its credit line and was losing the capacity to borrow from its bank.

An analysis of the balance sheet revealed that the inventory investment was growing significantly faster than the company's growth in gross margin dollars. Indeed, with average inventory growing 40 percent over the previous year, the company was literally overinvesting in inventory relative to the return in gross-margin dollars.

Related: Inventory Out of Control? Take Stock With These 3 iPad Apps.

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, because this would have had a negative impact on gross-margin dollars.

The end result of this is that the excess inventory created a cash-flow issue that ultimately forced the company to borrow additionally 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.

Related: How Much Cash on Hand Is Too Much? And What Should I Do With It?

Calculating gross margin return on investment. And it brings us to a critical variable: gross margin return on investment (GMROI), defined by Investopia 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."

This is a useful measure, because 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 differ 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's critically important for middle-market companies that have working-capital challenges and that require additional funding to operate the business efficiently and effectively. \

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