Business owners and investors have to be familiar with a company’s finances to make well-informed decisions. There are several key numbers watched by investors that indicate the current health of a company.
Comparing revenue and profit from the current year to those metrics from the year prior reveals if a company is growing or losing market share. Looking at “year over year” profit and revenue numbers is one way to gauge how healthy a company is and whether it would be a good investment.
This guide breaks down revenue and profit as tools for making investment decisions. Throughout are examples of how real companies report their earnings and sales, and how investors can use that information to make judgment calls:
Revenue is the total money a company generates from sales of products and services. This is the “top line” item of an income statement. Businesses do not consider expenses when calculating top-line revenue.
Hank Smith, head of investment strategy at Haverford Trust Co., offers a brief definition of revenue and encourages business owners and investors to consider which products and services drive revenue: “Revenue is the money companies receive selling products or services. For example, Pepsi sells products, carbonated beverages and snack foods. On the other hand, a consulting firm such as Accenture sells a service, or in this case, advice.”
Business owners and investors can look deeper into revenue numbers, or sales, to discover which business segments generated the most revenue. For instance, Amazon.com Inc. (ticker: AMZN) reported that net sales increased 13% in the third quarter year over year, from $127.1 billion in Q3 2022 to $143.1 billion in Q3 2023.
In its quarterly earnings report, Amazon then put net sales into two categories: net product sales and net service sales. Net product sales reached $63.2 billion in the quarter, while net service sales came in at $79.9 billion. The company’s earnings report goes deeper into each of those two categories to reveal how much revenue came from each business segment.
Profit offers more context surrounding a company’s financials. While revenue is the top-line item on an income statement, profit is the “bottom line.” Revenue represents the income a business generates, while profit is a company’s net income.
Accountant Lisa Wood, director of tax for Buckingham Advisors, explains some of the expenses that help business owners and investors determine their profit: “Profit is the income earned less all expenses, including the costs of operating the business, taxes and depreciation. Profit also includes income from non-business activities such as investment and rental income.”
Business owners and investors analyze revenue and profits to understand growth rates and assess the health of companies.
Year-over-year comparisons are important because while $100 billion in revenue may sound like a good quarter for a company, this figure would be concerning if the company generated $150 billion at the same time last year. Dropping from $150 billion in revenue to $100 billion represents a 33% year-over-year decline.
Investors should look for companies that are growing their revenue year over year. Revenue growth indicates that the company’s efforts to gain market share are bearing fruit.
Investors would be happy to see a company go from $100 million in revenue to $150 million in revenue, representing a 50% year-over-year jump. However, high revenue growth accompanied by substantial net losses can deter investors. Some growth companies report exceptional year-over-year revenue growth while losing millions of dollars in the same quarter.
Snowflake Inc. (SNOW) is a good example of this. While the relatively young company posted 36% year-over-year revenue growth in the second quarter of fiscal 2024, it also posted a net loss of $227 million in that quarter.
Companies like Snowflake hope that they can focus on high top-line growth during their early stages and then focus on bottom-line growth as the business matures. “Companies can stay in business by securing additional funding through debt or adding additional investors,” Wood explains.
Enough investors have to be on board with the business model for an unprofitable company to stay afloat. Any revenue deceleration can scare away investors.
While the Snowflake example demonstrates how substantial losses can minimize the impact of high revenue growth, there are more ways to analyze profit. Looking at a company’s profit margin can reveal how efficient the company is at preserving capital.
For instance, a company with a 25% profit margin holds onto 25 cents out of every dollar earned. If a company grows its revenue by 15% year over year and maintains a 25% profit margin, then the company also grows its profits by 15% year over year.
If the profit margin stays constant or within a small range, revenue and profit growth will be similar. A rising profit margin means net income growth is outpacing revenue growth, while a declining profit margin indicates revenue growth is outpacing net income growth.
Some companies achieve higher year-over-year profit growth than revenue growth because of effective cost-cutting measures that don’t interrupt core revenue opportunities. A company with high revenue growth with flat earnings is suddenly spending more money to acquire each dollar.
While investors give new corporations more leniency, mature companies don’t get the same leeway if profits decline or stay flat.
“For more mature, established companies, profit growth is as or more important than revenue growth,” Smith says. “It must be pointed out that in the long term, a company’s stock price often correlates directly with growth in profits.”
Investors and business owners can look at a company’s individual segments to see which ones are driving the biggest shifts in revenue and profit. Some segments generate significant revenue growth but struggle to break even. Other segments have moderate revenue growth but maintain the same profit margins, which means profits go up, too.
While businesses have many revenue segments, each revenue segment belongs to one of two categories: operating or non-operating revenue.
Operating Revenue
Operating revenue comes from business activities. Each time someone buys a product on Amazon, the company generates operating revenue. The corporation generates this revenue because of the business model.
Non-Operating Revenue
Non-operating revenue entails all revenue sources that are not a direct result of the business. If a company exchanges its British pounds for U.S. dollars, for instance, the company can generate non-operating revenue if the pound gains or loses value against the U.S. dollar.
A currency exchange can increase or decrease revenue, depending on the exchange rate. So, currencies are a type of non-operating revenue source. Returns from investments also count as non-operating revenue.
For instance, Amazon receives payments in various currencies. Without the favorable impact of exchange rates throughout the third quarter, which represented $1.4 billion, Amazon’s net sales increased only 11% compared with Q3 2022, rather than 13%.
This article has focused on net profit, or the bottom-line item for income statements. However, investors and business owners can look at two additional types of profit to gauge a company’s performance.
Gross Profit
Gross profit is the difference between a company’s revenue and the cost of goods sold. Each good has several costs, such as for purchasing necessary materials and shipping them to their locations. These costs reduce revenue and help investors arrive at a company’s gross profit.
Operating Profit
Operating profit takes it a step further. This profitability metric includes operating costs and indirect expenses. It ignores interest and taxes. Operating profits reveal how effectively a company can convert sales into profit.
Business owners can improve operating profits by reviewing their overhead. Cutting too much overhead can impede a company’s ability to operate smoothly, so business owners and analysts must seek the perfect balance.
Net Income
Net income indicates how much money a company has earned after all expenses. If interest and tax payments consistently result in a net loss, the company may have a hard time staying afloat.
Business owners analyze all these metrics and look for opportunities to make them more attractive. For example, lowering the cost of goods sold or increasing the prices of products makes gross profit margins more enticing. Higher gross profits will trickle down to operating profits and net profits.
Takeaway
Investors should compare year-over-year results and monitor changes in net income, revenue and other metrics on company earnings reports. Staying on top of these key results helps investors and shareholders make better decisions about their investments.
