Revenue, Gross Income, and Net Income

Oftentimes the terms revenue, gross income, and net income are incorrectly used as synonyms. While all three are related, they are different in what they mean and their function for an investor to make informed decisions.

Imagine a T-shirt screen printing company, Bob’s T-shirts. The business purchases shirts in bulk and can screen print shirts with any logo a customer wants. Bob’s T-shirts sold 55 finished, screen-printed shirts last month at an average cost of $27.50 a shirt. This means Bob’s monthly revenue (55*27.50) was $1512.50.

However, Bob had to purchase the shirts in bulk, run the screen printer, and buy the letters and logos for screen printing. These inputs that go into producing the shirts are called the cost of goods sold. This is an accounting number which can vary from several factors: how does a company recognize the direct costs of labor in making a product? Is someone’s full time job making shirts? Are they included in the cost of goods sold?

Another nuanced point is how does the company mark the finished goods in their books? Do they record sales of the oldest shirts first (Last in First Out or LIFO), sales of the newest shirts first (First in First Out or FIFO), or does the company average the costs of all goods in recording sales (Average Cost Method)? A sound investor can read into annual reports and find how a company recognizes revenue.

Regardless of the accounting nuance, here is what we have so far:

Revenue – Cost of Goods Sold = Gross Profit

The gross profit, sometimes called gross income, is a snapshot that shows how efficiently a company manages their production process.

As you move down the income statement, the last line is net income. Between the top line of revenue and the bottom line of net income, you already encountered gross profit. The income statement should have a funnel effect, starting with the largest number at revenue, a slightly smaller number at gross profit, and an even smaller number at net income. If an income statement does not follow this trend, the company is likely committing accounting shenanigans.

For a sample look at an income statement, click here: Income Statement.

Revenue – Cost of Goods Sold = Gross Profit

Gross Profit – Selling, General, and Administrative + Other Expenses = Operating Income

Operating Income – Interest Expenses – Taxes +/- Other income (losses) + Net Income from Continuing Operations = Net Income

Don’t be intimidated by all the terms. For a quick snapshot to understand a company, revenue and net income answer the two questions one must understand first. Revenue: How much money did Bob’s T-shirts take in? Net income: How much money did Bob from Bob’s T-shirts make after he paid all his bills?

Both revenue and net income have their rightful place in evaluating Bob’s T-shirts as a prospective investment. It is certainly easiest for a potential investor to analyze Bob’s T-shirts based on net income. If you bought 10% of Bob’s T-shirts, you could expect to collect approximately 10% of his stated net income assuming T-shirt sales hold up and the business maintains the same efficiency in producing shirts.

However, as seen in calculating cost of goods sold, there are many ways to manipulate accounting of Bob’s business. For example, did Bob overpay for the last batch of shirts and choose to use FIFO accounting for his shirts to make it appear his cost of goods sold is lower than it is? This type of manipulation can occur all the way down the income statement, meaning a business that loses money can be engineered to look more financially sound when it is not.

This is where revenue comes in. Revenue, although inefficient for valuing a business’ net income generation, is extremely difficult to manipulate. Largely speaking, the amount of shirts Bob sold multiplied by the sale price of the shirts is revenue. As a T-shirt business, Bob would be hard pressed to fudge this number.

*In a traditional W-2 job, gross income (salary) is the income before taxes, social security, Medicare, company pension, health insurance, etc. Net income is the money you get deposited in your account and can spend.

 

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