Red flag: margin compression

Interpretation

Triggered when gross margin has fallen more than 5 percentage points versus three fiscal years ago.

Formula

Trigger: current gross margin < gross margin three years prior − 5 points

Why it matters

Gross margin is where competitive position shows up first. Erosion of this size rarely comes from cost inflation alone — it usually means the company is cutting prices to hold volume, its product mix is shifting toward lower-value offerings, or competitors have broken its pricing power. Because gross margin sits above every operating expense, a 5-point loss flows straight through to operating and net margins unless overhead is cut to match, which has its own costs.

What good looks like

When triggered, find the driver: input-cost spikes (may reverse and can sometimes be repriced later), mix shift (may be a deliberate strategy — hardware companies growing lower-margin services, for example), or price competition (the structural case that most often precedes long-term decline). Management's explanation in the 10-K's MD&A section, and whether the erosion is decelerating, are the key evidence.

Caveats

The check compares two points three years apart, so a temporarily depressed latest year (commodity input spike, inventory write-down) can trigger it without structural change. Some strategic transitions legitimately trade gross margin for a larger or stickier revenue base. Cost-classification changes between cost of revenue and operating expense can also move the ratio without any economic shift.