Income Statement Top Line vs. Bottom Line
Sustainable Success Requires Mastering Both
Have you ever heard someone in the investing and business world refer to something as being either "top line" or "bottom line"? What do these terms mean, you might ask? How does the top line differ from the bottom line and why do they matter?
Sooner or later, you might need to know the answer to these questions, especially if you decide to start investing. The income statement top-line is total revenues, while the bottom-line (for investors) is net income applicable to common shares.
Many people have enjoyed affluence only to lose it all because they didn't understand that the top line and the bottom line do not necessarily move in tandem. In some cases, sustainable investing success requires understanding the top and bottom lines, and everything in between.
Line Items on an Income Statement
If you are familiar with how to analyze an income statement, you may recall that every income statement, or Profit and Loss (P&L) statement, as they are sometimes known, is broken down into sections. At the top, you begin with sales or revenue, which generally refers to the money a company generated by providing goods or services to its customers.
When you hear someone refer to the "top line," they are usually referring to the top line item on the income statement, total revenue. If you owned a Cinnabon franchise, for example, the top line is going to be how much cash you brought in from selling cinnamon rolls and cups of coffee.
The (Real) Bottom Line
As you continue scanning down the income statement, you'll see entries for different types of expenses or income. You finally arrive at the last line, where you sometimes find an item known as Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA); this is not the bottom line. Other statements might show net income or net earnings as the last line. This is the line item officially referred to as the bottom line on an income statement, whether it is the last line or not.
EBITDA can be a deceiving number for some investors when it is the last line item. You shouldn't view it as the total amount of earnings, but rather how much was earned after all deductions were made, but before interest, taxes, asset depreciation, and amortization were deducted. A corporation that lists EBITDA as its bottom line needs to be investigated further to distinguish their net income.
EBITDA is not net income. It excludes interest, taxes, equipment depreciation, and loan amortization—which all have to be paid from earnings. It doesn't help an investor determine much about a stock.
Investors generally use the line labeled "net income applicable to common shares" (or similar), which is the profit stockholders are most interested in. This is the portion of income that is available for shareholder dividends.
This figure is also used to calculate basic and diluted earnings per share, which divides the available income by the number of outstanding shares for the former, and for the latter subtracts any dilutions (new shares issued, shares converted, or any action that reduces the value) before dividing by the outstanding shares.
Other Important Line Items
Beyond that, there are some other terms and profitability concepts you should know. When an executive, analyst, investor, or business owner talks about profits, he or she may be referring to one of three different types of profit:
- Gross profit: Gross profit refers to the total revenue minus cost of goods sold.
- Operating profit: Operating profit refers to the total pre-tax earnings of an enterprise from the operating activity in which it is engaged. It is calculated by taking the gross profit and removing items that fall into a category known as selling, general, and administrative expenses.
- Net profit: This is the bottom-line profit after all expenses, taxes, interest, and other costs have been paid, depreciation has been estimated, and the books have been closed.
Furthermore, when a person refers to gross profit, operating profit, or net profit, they may be referring to the actual figure expressed in a given currency (e.g., "The bottom line for the year? We made $1.2 million in profit!"), or they may be referring to a relative financial ratio known as a profit margin.
Specifically, they may be referring to the gross profit margin, operating profit margin, or net profit margin (each will tell you how the different types of profit compared to overall revenue). Again, context is important.
Use Profit and Profit Margin for Basic Valuation Analysis
Once you have figured out the top-line and bottom-line figures, you can go one step further and use them to perform some basic valuations on different companies. One formula for valuing a stock's growth breaks out three different valuation multiples that a person can use to try to compare how "expensive" one company is to another, at least on a first-pass basis. The three metrics include:
- The price to earnings (P/E) ratio, which tells you how expensive a company is relative to its net income
- The price to earnings growth (PEG) ratio, which attempts to adjust the P/E ratio for growth in the underlying profits
- The dividend-adjusted PEG ratio, which goes one step further and attempts to factor in not only growth but dividend income
Things to Keep in Mind
Whether you're a lender, investor, manager, or business owner, there are a few takeaways you should remember about top-line and bottom-line profit figures.
First, it is possible for an enterprise to increase the top line (sales) while decreasing the bottom line (net earnings). Not all sales are profitable. There are companies that have gone under because their sales increased too rapidly.
Second, it is possible for an enterprise to decrease the top line (sales) while increasing the bottom line (net earnings). Through cost-cutting, automation, and structural changes in the business, certain firms have been able to generate profits even in declining sectors and industries, making their shareholders rich.
Third, remember that in general, the ideal situation is one in which the top line and the bottom line are growing in tandem. However, most businesses have something known as operating leverage built into them. This comes into play with a measurement known as the interest coverage ratio (how many times a corporation can make its interest payments with earnings).
The Bottom Line
Basically, there is a certain level of fixed expenses in the business—rent, payroll for employees, and utilities—that eat up a lot of profit below a certain top-line figure. Once this is crossed, a huge percentage of the additional sales above that magic line drop straight to the bottom line.
Those incremental sales, in other words, are far more profitable. An intelligent investor can make a lot of money buying into a bad business that is about to turnaround, in effect harnessing the fact that an increased revenue (the top line) can result in an increase in net income (the bottom line).