Overview – Learning to Look Beyond the Bottom Line
Most investors are quick to celebrate when a company they’re invested in reports a profit over the previous fiscal period. It feels even better when profit has consistently been reported for the past several years – after all, sometimes all it takes is a major global event or an unexpected shift in the business environment for a company to suddenly find itself reporting a yearly loss.
Every publicly-traded company shares a common goal: to turn a profit. There’d be no incentive to perform business in the first place if there wasn’t any money left to keep unless they are classified as a not-for-profit entity.
Unsurprisingly, profit is considered one of the most important metrics when assessing investment merit. It’s very hard to convince investors to commit their money to a business if it has a hard time producing a profit, or worse, it consistently reports losses year after year.
It’s easy to celebrate when profit is consistently being reported, but that doesn’t mean an investor can rest on their laurels when they see a big number at the bottom of an income statement.
Understanding how a company produces its profits in the first place is something every investor should take the time to do when performing their due diligence.
*Note: Throughout this article, the terms “profit”, “net income”, and “bottom line” will be used interchangeably.*
A Refresher on Profit
In case you’ve forgotten how profit is calculated, or if you’re unaware of how profit is calculated in the first place, let’s quickly go over what it is. Profit, in equation form, is expressed as:
Profit (Net Income) = Total Revenue – Total Expenses
It’s important to note that this is a general form, that is, this equation may take on some slight variations based on the company it’s being used on.
For example, let’s look at Manulife Financial’s 2020 Income Statement, shown below:
Revenue is very easy to extract since it’s clearly marked as “Total Revenue”, with a value of $78,908 (millions of CAD). However, things get slightly tricky when it comes to total expenses.
Notice that Manulife’s expenses fall under two major categories:
- Net Benefits and Claims
- Other (General Expenses, Investment Expenses, Commissions, Interest Expense, Net Premium Taxes)
These expenses amount to $72,137 (millions of CAD).
Income taxes are always present in every income statement as an expense, so they must also be included in this equation.
So, going back to our general profit equation, the profit for Manulife Financial in 2020 can be calculated as follows:
Profit = Total Revenue – Total Expenses
Profit = $78,908M [Total Revenue] – ($72,137M [Expenses] + $1,195M [Income Taxes])
Profit = $5,576M
The general profit equation will always look different based on the company being analyzed, but at its core, it always calculates the same thing and always uses the same variables (although they take on different forms).
While this equation is very simple to follow, some investors don’t take the time to look at it a bit deeper, and as a result, don’t ask themselves some very important questions.
(For more on how to go over the financial statements, refer to this article. For more on introductory accounting concepts, go here.)
The Two Ways to Increase Profit
Going back to our general equation, we can see that there are two ways to increase the bottom line: earn more revenue, or reduce expenses.
With this in mind, the logical response would be “Well, shouldn’t companies just focus on maximizing revenue while simultaneously minimizing expenses?” In a perfect world, yes. But in practice, this is usually easier said than done.
That’s because every time a company wishes to sell something, there are expenses associated with that sale. This is usually known as the “cost of goods sold”. Companies can’t just earn money from nothing, that is, they must first spend some money before earning it.
For example, before Apple sells an iPhone, the unit must first be manufactured, which has an associated cost. Apple then sells the phone at a price higher than the manufacturing cost in order to make a profit from it. The same can also be observed for companies that provide services: before the service is administered, there are associated costs needed to prepare it.
So, a company can either earn more revenue while simultaneously finding a way to keep expenses in check or find ways to cut out superfluous expenses. Let’s dig deeper into those two options.
Increasing Profit by Earning More Revenue
There’s no such thing as a company that earns too much money. Companies fail all the time because of insufficient revenue, but not a single company has failed because they generate too much. Therefore, the most immediate way to increase profit would be to bring in more revenue.
Before we continue, let’s take a look at what constitutes revenue. Revenue, just like profit, can be expressed in equation form, as follows:
Revenue = Unit Price * Number of Units Sold
“Unit” can either refer to a product or service, while the number of units sold can either refer to the number of products sold or the amount of time the service was provided.
If a bakery charges $3 for a loaf of bread, and they sell 100 a day, then they generate $300 in revenue from loaves. If an engineering company charges $100/hour of engineering work, and they log 1000 hours on a given project, then they will have earned $100,000 in revenue.
So, to increase revenue, there are two ways to do so: charge more and/or sell more.
Increasing the unit price is arguably the easier approach to take because it can be done with minimal hassle and the result is almost immediate. However, this increase in revenue may be short-lived.
That’s because companies can run into an economic phenomenon known as “price elasticity of demand”. Put simply, consumers decide how much of a good to buy based on its price. If the price changes, so too does the amount purchased. Price elasticity of demand studies that relationship.
The more “elastic” a given product/service is, the more sensitive consumers are to price changes. For example, you may be willing to buy 20 chocolate bars at $1 each, but if the price suddenly jumped to $5, you may only be willing to buy 1.
So, if a company plans to increase revenue by charging more for their product/service, they’ll need to ensure their customers aren’t overly sensitive to price increases, otherwise, they run the risk of losing business or for the price increase to only work in the short-term.
In the event that a price increase is unfeasible, then the alternative would be to sell more units while keeping the price unchanged.
For many companies, this is a realistic option, especially if they have the means to produce/provide greater units and have access to additional markets. An example is the iPhone, which can be mass-produced relatively easily and is sold almost anywhere around the world.
The major assumption being made when selling more units is that the cost of goods sold doesn’t increase at a commensurate rate, otherwise, the additional revenue will simply be cancelled out by the increased expenses.
Increasing Profit by Cutting Expenses
Sometimes, a company may find it difficult to grow its revenue. Perhaps their customers are very sensitive to price increases, or maybe they don’t have the means to sell more. Therefore, the only remaining option to increase profit would be to cut expenses.
In certain situations, this option makes a lot of sense. A company that has a very bloated income statement due to excessive expenses can improve its profit margins by eliminating this excess, or by finding ways to reduce necessary ones as much as possible.
For some companies, they may struggle to turn a profit not because they don’t generate enough revenue, but because they don’t realize how much money they’re burning on expenses that shouldn’t exist in the first place.
One of the nice things about cost-cutting is that it’s relatively easier to do than trying to increase revenue.
If a company seeks to increase its revenue by increasing the price of certain products/services, then it’ll need to understand the price elasticity of demand for those products/services, determine what the “sweet spot” is for a prince increase, and successfully convince its customers that this price increase is justified.
Wanting to sell more units of a product/service sounds great, but not every company has the capacity to sell more and/or may not have extra customers they can sell to. If a company chooses to acquire extra capacity and/or customers, then it’ll most likely involve significant time, effort, and money, while having no guarantee that all that effort will result in increased revenue.
Cost-cutting, on the other hand, is usually a one-and-done ordeal. A company can sell property, plants, or equipment they no longer need, can relocate their manufacturing to cheaper countries, and can outsource certain tasks to be done for cheaper overseas: the list goes on.
While reducing costs never hurts to do and is usually viewed favourably by investors, there is a major caveat: a company can’t cut costs forever.
Eventually, there will be no costs left to reduce or eliminate.
Unlike revenue, which can keep on growing ad infinitum, there are only so many costs that can be reduced or eliminated until there are none left to cut out. A company will eventually reach a point where the expenses they do have left are absolutely necessary for the day-to-day operation of the business.
Therefore, increasing profit via aggressive cost-cutting is a viable strategy, but only works up to a certain point. If a company wishes to turn a profit in the long term, it’ll have no choice but to focus on revenue growth instead of further cost reduction.
It Never Hurts to Ask How the Bottom Line Was Achieved
It’s no secret that the business world is extremely competitive. So, in a world with lots of competition and limited investment capital to go around, companies go to great lengths to try and convince investors to park their money with them.
In a desperate attempt to try and beat the competition, some companies perform some financial sleight of hand to make their financial situation seem stronger than it really is.
Although a publicly-traded company’s financial data is audited, this doesn’t mean management will explicitly tell investors how they achieved their profit. It’s easy to brag about increased revenue, but dramatic cost-cutting in an attempt to inflate profit isn’t something most companies would enthusiastically share.
It’s an investor’s responsibility to ascertain how a company achieves its profit and to determine whether its approach is sustainable or not.
Investment analysis is, in a sense, just a form of detective work: investors look at the information presented to them and analyze what exactly is going on, while at the same time trying to detect if anything is amiss.
It never hurts to ask yourself how exactly a company’s results were achieved. One of the worst things that can happen to an investor is to mistakenly believe that everything is in order, only to find out later that they have been deceived.
Wrapping Up
Many investors celebrate whenever they see a company they’re invested in turning a profit, but not as many investors take the time to ask how exactly that result was achieved.
There are two ways to increase profit: earn more revenue (while keeping costs unchanged/reducing them), or cut costs (while revenue remains the same). Of course, both approaches have their merits and drawbacks.
Prices can be increased and sales volume can be upscaled, but some customers may not take too kindly to large price jumps, while some companies may not have the ability to sell more.
While a company can cut expenses relatively easily, there’s a limit as to how much they can be reduced. Eventually, there will be no more unnecessary expenses left to cut, and the expenses that do remain are vital to daily business operations.
Companies will gladly share that they’ve turned a profit, but very few of them will be as open when describing how exactly that was achieved. It’s up to investors to dig deeper to find the answer to this question and to judge whether the approach taken to earning profit is sustainable or not.
