Imagine this scenario. It’s earnings season and stock market news sites are brimming with quarterly performance reports coming from all the companies that matter and everything else in between. Stock exchange activity becomes volatile as a result, with positive or negative reports influencing investor sentiment about particular companies or entire sectors more broadly. Intrigued, you try to read the analysis in order to reach your own conclusions about where to put your money—but then you’re stuck.
Never mind the digits and percentage points—you’ll deal with that after you’ve wrapped your head around the jargon. This is when you realise that terms like ‘revenue’ and ‘income’, which initially seem interchangeable, actually represent different figures upon closer inspection, and there seems to be a host of nuanced distinctions between other similar concepts like earnings, sales, profits and gains. So what does all this mean and where does it leave your investments?
In this article, we’re going to focus specifically on terms like revenue and income—as well as their subcategories and variations—so that you are able to filter out the information you require before investing in the company of your choice.
Contents:
- What is revenue?
- What is income?
- Why are they important for investors?
- What is EPS?
- Does higher revenue mean higher profit?
- Is net income a more reliable indication than revenue?
- Are profits and gains the same thing?
What is revenue?
The money generated by a business or company’s operations is called revenue. It is also known as sales or gross income.
For example, take a bookshop owner who is calculating the revenue for his business. This would be based on how many sales his business has made, which is in turn calculated as the average sales price multiplied by the number of items (in this case, books) sold.
Companies may decide to calculate the money brought in by their business activities in different ways. With accrual accounting, all sales are registered as revenue, even if no cash payment—called ‘receipt’—has been made yet. In this case, a sale made on credit will also be considered as revenue.
On the other hand, there is deferral accounting, where only sales for which cash has been collected and the service rendered or goods delivered are included in the calculation of revenues. Here, a company might have collected receipts that are not yet showing in its revenues.
In short, accrual accounting takes into consideration cash it is yet to receive while deferral accounting delays the recognition of the transaction until it is fully complete.
What is income?
Simply put, this is revenue minus the costs. If revenue is the starting point or the top line, net income is the corresponding endpoint and bottom line. Let’s see how.
To go back to our book shop analogy, imagine that the revenue has been very high and the bookshop owner has made many sales. However, he has also had to use money from his revenue to resupply his stocks, pay rent for his premises, and pay his taxes, for example. What he is left with after all those subtractions is the net income. This is why it is important to distinguish between gross income or revenue on the one hand, and net income on the other, which is the portion of earnings a company can really call its own.
Net income, which is also known as net earnings, is a company’s earnings minus expenses such as costs related to its production, operation and administration, as well as other deductions in the form of taxes or depreciation, to name a few.
There are two types of net income. Operating income is net income after operating costs have been subtracted from revenue, while non-operating income is derived from peripheral sources as one-offs, as with the proceeds from a lawsuit or an acquisition, for example. The former is a more reliable indicator of how well a company is doing.
Fun fact
The expression, ‘the bottom line’, comes from the corporate world of 1960s America and describes the physical bottom line of an earnings report, where the net income is placed, showing whether a company made a profit or took a loss. Net income is also known as ‘the bottom line’ for this reason, while revenue is ‘the top line’ because it is placed first in an earnings statement.
Why should investors pay attention to revenue and income?
If revenues exceed expenses, the company has made a profit, which is why the net income is useful for investors to assess a company’s profitability, financial health and prospects. Revenue and net income are normally considered separately, and although they are not entirely mutually dependent, for a company to boost its profits, it needs to maximise revenues while minimising the costs that detract from its earnings.
Ahead of each earnings season, analysts publish their expectations for a company’s performance. How wide a company’s actual revenue and profit statement falls off the mark will lead to fluctuations in its share price, with underperformance lowering investor confidence, and vice versa.
What is EPS (earnings per share)?
Another good measure to stand by is the EPS, or earnings per share. This figure is calculated by dividing a company's net profit by the number of common shares it has outstanding. EPS is therefore a marker for how much money a company makes for each share of its stock and analysts often look to the EPS to estimate a business’s corporate value. The higher the EPS, the greater the company’s value, since investors will be willing to buy more expensive shares for stocks that generate higher profits.
Does higher revenue mean higher profit?
No, not necessarily. In fact, a company may even have positive revenue results but negative profit. This happens if it does not manage to contain its expenses and its costs exceed its revenue, even though it may be generating a lot of money from sales.
Net income does not generally exceed revenue, although this might be the case if a company receives non-operational income from a one-off transaction or investment.
Is net income a more reliable indication than revenue?
Net income is not called ‘the bottom line’ for nothing and it is generally felt to be more important, even as revenue figures are still indicative. A company’s success and longevity is intimately linked to its profit, and no one wants to invest in a business that depends on outside sources or debts to stay afloat. But if you really want to determine just how strong a potential investment is, you will need to consider both a company’s revenue and net income, precisely because they represent different elements of a company’s earnings.
Revenue figures reflect how well a company is able to generate sales from its products or services. For example, a company that declares high revenue earnings might be doing well in terms of a new product launch. However, revenue does not indicate how efficiently a company handles its general operations and you will need to look at the net income for that.
Furthermore, the method with which revenue is calculated, whether through accrual or deferral accounting, is also significant as it might allow companies to inflate their sales. For this reason, a company is also obliged to publish its cash flow statement, which reveals whether the business entity in question is able to efficiently collect the money it has already included in its revenue statement.
Considering a company’s net income solely does not give you the full picture either. Since profit is generated from either increased revenues or cost-cutting strategies—and more often than not, a combination of both—a company might manage to boost its profit by reducing expenses but without developing its production and operations, which means that its revenue remains stagnant year-on-year. Some companies might also manipulate their figures by presenting revenue in a more competitive light than it actually is while hiding expenses. This is not something you want to see in a potential investment choice since it does not foster much hope in long-term growth.
While a promising total revenue evidences a successful sales approach, a lagging income might testify to unsustainable company management strategies in general. This is why both elements need to be taken into account for a more accurate appraisal.
Are profits and gains the same thing?
Once again, although these two words seem synonymous, they refer to slightly different results and calculations, even as they both bode well for a company.
Profit is any money left over after expenses are deducted from revenue to generate what is called a positive net income. A negative net income, on the other hand, means the company’s revenue was not sufficiently profitable to cover the costs.
A company can generate profit through its primary operations and production processes but extra income can also be derived from non-primary sources. Such secondary avenues may include lawsuit pay-outs, investments, or the selling of assets. Any money coming from these peripheral activities is known as gains.
And if any money is lost through these secondary activities, this is known as loss. A company can therefore make a loss if it loses any money on a financial investment or an unsuccessful lawsuit.
While activity in the stock exchange can often seem unruly and incomprehensible, crunching the numbers on an earnings report can help anyone—from trade veterans to novice investors—understand at least some of the motives behind trade fluctuations.
The financial data concerning a company’s performance is made available on a quarterly and annual basis. By learning more about the terms involved in such reports, a newcomer to the stock market can begin to make better sense of information that would otherwise get lost in all the jargon.
The publication of a company’s financials can sometimes lead to volatile days on the stock exchange, but it is important to appreciate that earnings reports require further analysis for their full implications and import to be made clear. Long-term investment planning should not be at the mercy of a one-off report because the way the stock market works and a company’s general success are far more intricate than a single figure may suggest. You can read more about earnings reports in this introductory guide and if you want to learn more about how to build your investment portfolio, click here.
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