9.2 Key Concepts

Revenue as an Investor Signal:

Revenue, also commonly known as sales, is generally the most straightforward part of the income statement. Often, there is just a single number that represents all the money a company brought in during a specific time period, although big companies sometimes break down revenue by business segment or geography. The best way for a company to improve profitability is by increasing sales revenue. For instance, Big Bazaar has aggressive long-term sales growth goals that include a distribution system countrywide. Consistent sales growth has been a strong driver of this company’s profitability. The best revenues are that are steady throughout the year. Temporary increases, such as those that might result from a short-term promotion, are less valuable.

What Are The Expenses?

There are many kinds of expenses, but the two most common are the cost of goods sold (COGS) and selling, general and administrative expenses (SG&A). Cost of goods sold is the expense most directly involved in creating revenue. It represents the costs of producing or purchasing the goods or services sold by the company. For example, if Big Bazaar pays a supplier Rs 40 for a box of soap, it may decide to sell it to a customer for Rs 50. When it is sold, Big Bazaar’s cost of the product sold for this particular box of soap would be Rs 40.Next, costs involved in operating the business are cost of goods sold. This category includes marketing, salaries, utility bills, technology expenses and other general costs associated with running a business. Selling, general and administrative expenses (SG&A) also include depreciation and amortization. Companies must include the cost of replacing worn-out assets. Remember, some corporate expenses, such as research and development (R&D) at technology companies, are crucial to future growth and should not be cut, even though doing so may make for a better-looking earnings’ report. Finally, there are financial costs, notably taxes and interest payments, which need to be considered.

Profits = Revenue – Expenses

Profit, most simply put, is equal to total revenue minus total expenses. However, there are several commonly used profit sub-categories that tell investors how the company is performing. Gross profit is calculated as revenue minus cost of sales. Returning to Big Bazaar again, the gross profit from the sale of the soap would have been Rs 10 (Sales price of Rs 50 less cost of goods sold Rs 40 = Gross profit Rs 10). Companies with high gross margins will have a lot of money left over to spend on other business operations such as R&D or marketing. So be on the lookout for downward trends in the gross margin rate over time. This is a tell tale sign of future problems facing the bottom-line. When the cost of goods sold rises rapidly it is likely to lower the gross profit margins - unless, of course, the company can pass these costs on to the customers in the form of higher prices.

Operating profit is equal to revenues minus the cost of sales and SG&A. This number represents the profit a company made from its actual operations, and excludes certain expenses and revenues that may not be related to its central operations. High operating margins can mean that the company has an effective control of costs, or that sales are increasing faster than operating costs. Operating profit also gives investors an Opportunity to do profit margin comparisons between companies that do not issue a separate disclosure of their cost of goods sold figures (which are needed to do gross margin analysis). Operating profit measures how much cash the business throws off, and some consider it a more reliable measure of profitability since it is harder to manipulate with accounting tricks than net earnings.

Net income generally represents the company’s profit after all the expenses have been paid. This number is often called the ‘bottom-line’ and is generally the figure people refer to when they use the word ‘profit’ or ‘earnings’. When a company has a high profit margin it usually means that it also has one or more advantages over its competition. Companies with high net profit margins have a bigger cushion to protect themselves during hard times. Companies with low profit margins can get wiped out in a downturn. And companies with profit margins reflecting competitive advantages are able to improve their market share during the hard times - leaving them even better positioned when things improve again.