Whenever I watch CNBC, perhaps the best channel for financial news, I frequently hear the terms: “top line” and “bottom line”. These are especially relevant at times such as this, when corporate earnings are being announced. Top line refers to a company’s Total Revenue received, during the course of a Quarter or a Year. It is generally listed at the top of a Simple Income Statement.
Think of a Family on a tight budget, watching their expenses. They might take out a lined tablet, write the combined Family Income at the top, subtract the total payroll deductions, plus regular expenses, such as rent/mortgage, car loan(s), food, etc. That would leave them with “Disposable Income”, to be used as they see fit. At the bottom of the sheet, they would see what they are either ahead for the month, or behind. That would be comparable to a company’s net income, or loss.
If you would like to see what a real Corporate “Income Statement” looks like, just go onto the web site of any large corporation, such as Bank of America, General Electric or IBM. You should be able to find the most recent Annual Report, which all public corporations are required to publish annually. The pages and pages of detail, mostly due to accounting items, will totally blow your mind. That’s why I would suggest just focussing on the basics of an (Simple) Income Statement.
This morning, I noticed that Ford Motor Company beat the bottom line estimates (will discuss shortly); but, it fell slightly short of the top line estimates. Generally, the price of a stock moves somewhat toward consensus analysts’ estimates for such things as: sales; revenue; net income and even specific sales items (i.e. new cars, homes or iPads). But, what’s more important: Revenue or Income? Actually, Both! Taken together, they provide hints as to what goes on between production and sales.
In many cases, a small slip on revenue, with good earnings, can mean such things as: strong management; a statistical blemish; or an unforeseen increase in raw materials (i.e. lumber, steel, computer chips, etc.), energy or interest costs. However, oftentimes, it can mean a creative Accounting Department. Banks, for instance, transfer excess revenue (during good times) into reserves for bad loans; so, that way, they can reverse the process–transferring that money back into revenue–to smooth things over when earnings are short. In essence, why pay tax on earnings that you know might never be collected?
Perhaps one or two quarters where revenue slips might not be a major concern, if there appears to be an acceptable reason; however, the Financial Markets are, by then, scrutinizing the company’s earnings more closely. After a period of time, unexplainable problems and creative accounting will never replace true revenue growth.
One last concept, which is important to be aware of, is the difference between fixed and variable costs. This might provide some insight into profitability. Fixed costs (i.e. Plant, Equipment, Headquarters Staff, etc.) are those that a company will incur, month in and month out, because they are not based on Production or Sales Activity.
Variable Expenses, however, are wages, raw materials and other expenditures incurred, either due to an additional production shift or more efficient production or shipping activities. Production expansion might include additional fixed costs; but, they definitely should add to variable expenses. The expansion would probably increase the supply of products to be sold and potentially reduce the unit sale price (revenue). It would be up to the Finance Department to recommend whether the expansion would be feasible, given the additional cost and potential revenue to be gained.