The Top Line vs. the Bottom Line on an Income Statement
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 should you, or anyone else, care?
Sooner or later, you're going to need to know the answer to these questions, especially if you want to be successful in life. A lot of 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 most cases, sustainable success requires mastering both.
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), 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. As you go further down the income statement, different amounts are taken out or, in some cases, added, to reflect different types of expenses or income. You finally arrive at the bottom, where you find a figure known as net income applicable to common shares, which is the profit the stockholders are entitled to enjoy after backing out things like costs, interest expense, taxes, minority stakes, etc.
It is that figure that is used to calculate something known as basic and diluted earnings per share.
When you hear someone refer to the "top line," they are usually referring to sales or net sales (the latter is sales adjusted for certain items). 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. If you hear someone refer to the "bottom line," they are usually referring to the net income applicable to common shares, which is the net profit after taxes (though some small business owners will use "bottom line" to refer to the pre-tax operating earnings, so you'll need to clarify the context).
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 backing out things 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 estimated, and the books 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).
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:
Beware of a Certain Type of "Profit" Known as EBITDA
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. In essence, it is the amount of money that would have been made if a company did not pay interest charges, taxes, depreciation, and amortization. By now you should be asking yourself, "How can you ignore those costs? They still exist even if you pretend they don't!"
Exactly. It's similar to pretending that the interest you pay on your credit cards, your income taxes, and the depreciation on your car isn't real expenses to you. According to the EBITDA standards, they don't exist. If you can't tell, although you will hear a lot of professionals talking about this number, it is one of the most worthless, deceitful and meaningless figures available. Most investors are best served by paying absolutely no attention to it.
Things to Keep in Mind
Whether you're an investor, manager, a lender, or business owner, there are a few takeaways you need to remember about the 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 broke 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 mint money even in declining sectors and industries, making their shareholders rich.
Third, remember that, generally, 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 something known as the interest coverage ratio. Basically, there is a certain level of fixed expenses in the business—the rent, the payroll for employees, keeping the lights on and the water running—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 increase of [x]% in the top line can result in an increase of [10x]% in the bottom line.