Understanding the Earnings of a Company
When attempting to understand the money a company earns, two important metrics that stand out include operating income and revenue. While they both showcase the money a company has made, they differ in terms of the methods via which they express said company’s earnings and in terms of the deductions and credits they employ in their calculations. Each of these metrics is of paramount importance for those hoping to analyse whether or not a company is performing adequately.
Understanding the Definition of Revenue
Revenue refers to the total amount of income a company generates via the sale of its goods or services. It is used to indicate the money generated prior to any expenses have been deducted. These expenses could relate to those associated with the business’s operations. Given that revenue is often positioned at the top of a company’s income statement it is often referred to as its top line. When a company is understood to have “top-line growth”, it implies that it’s revenue – or the money that it is directing inward – is increasing.
Business-related income is exclusively referred to when considering net sales or revenue. It can be understood to be the same as the income earned by a given individual. In case a company has additional sources of income from investments for instance, the income is not classified as revenue as it wasn’t generated as a result of primary business. Additional income of any kind is market out separately on financial statements and balance sheets.
Defining Operating Income
While revenue refers to the earnings of a company prior to any expenses or costs being subtracted, operating cost refers to a company’s profit once its operating expenses have been deducted. Operating expenses here are meant to indicate the costs associated with running the business on a daily basis. With operating income it is possible for investors to separate the earnings of a company’s operating performance from the interest and taxes applicable to it.
Depreciation, amortisation, and selling, general and administrative expenses or (SG&A) are included under operating expenses. Operating income does not take into account interest expenses, taxes, non-operating income or money drawn from investments in other companies. Additionally, it doesn’t take into account any special or one-time expenses such as the cash paid for settling a lawsuit.
If you wish to calculate operating income you can reduce operating expenses from gross profit. This form of profit refers to the total revenue that has the cost of goods sold (or COGS) deducted from it.
Understanding Operating Income vs Revenue with an Example
It is important to understand that a given company’s operating income can vary quite dramatically from its revenue. In order to understand this better, take into account the example provided below which illuminates the differences between the two figures.
The table provided below highlights an instance wherein the revenue and operating income differ for company ABC’s income statement for the year 2018.
When looking at the table below you will notice that the company’s total net sales or total revenue amounted to the same figure. Net sales refer to the revenue that has returned merchandise deducted from it – it is common for retailers.
You will also note that the operating income for Company ABC is positioned lower down in the statement once expenses associated with its operations have been deducted. Expenses that have been taken into account include the cost of goods sold which amounted to INR 8.1 billion as well as costs not directly tethered to production i.e., SG&A which amounted to INR 3.4 billion. They collectively amounted to INR 12.39 billion thereby giving rise to an operating income of INR 116 million.
|
Income Statement for 2018 Year-end Company ABC |
|
| (INR in millions, except per share data) | As Reported |
| Total net sales | INR 12,506 |
| Credit income and other | – |
| Total revenues | INR 12,506 |
| Costs and expenses / (income): | |
| Cost of goods sold (exclusive of depreciation and amortisation shown separately below) | INR 8,174 |
| Selling, general and administrative (SG&A) | 3,468 |
| Pension | 21 |
| Depreciation and amortisation | 570 |
| Real estate and other, net | (146) |
| Restructuring and management transition | 303 |
| Total costs and expenses | 12,390 |
| Operating income / (loss) | 116 |
| Other component of net periodic pension cost/ (income) | – |
| Loss on extinguishment of debt | 33 |
| Net interest expense | 325 |
| Income/ (loss) before income taxes | (242) |
| Income tax expense/ (benefit) | 126 |
| Net income/ (loss) | INR (116) |
| Earnings/ (loss) per share: | |
| Basic | INR (0.37) |
| Diluted | INR (0.37) |
| Weighted average shares – basic | 311.1 |
| Weighted average shares – diluted | 311.1 |
Simply put, company ABC earned an operating income amounting to INR 116 million whereas its total revenue amounted to INR 12.5 billion. When considered alone, INR 12.5 billion in revenue comes across as a particularly impressive figure, however, once expenses are taken into account, company ABC’s operating income only amounts to INR 116 million. Further, the company’s net income which refers to the actual profit the company made, actually amounts to a negative INR 116 million.
This means that the company ABC suffered a loss in 2018 that amounted to INR 116 once the interest paid on its outstanding debt had been taken into account. Paying this very debt is the reason that it was placed in the red. Despite this, though, the contrast that exists between the revenue figure and the operating income figure is striking.
Wrapping Up
After taking into account the differences that exist between each of these figures you should be able to understand better why it can be hard to analyze financial statements. Owing to this very fact it is important to consider multiple factors when assessing the profitability of a company prior to investing in it.
