You’ll have to know the answers to these questions if you begin investing. Many people didn’t know that the top line and the bottom line don’t always move in tandem. Long-term investing success requires understanding the top and bottom lines, and everything in between.
Reading the Lines on an Income Statement
The income statement, or profit and loss (P&L) statement, reports a company’s financial performance over a set time. You may recall that these statements are broken down into revenues and expenses if you’re familiar with how to analyze one. There are line items within these two sections. Line items on the income statement might include sales, cost of goods sold, and interest expense. Line items are key to top and bottom lines.
What Is the Top Line?
The top of the income statement begins with sales or revenue, which refers to the money generated by providing goods or services to customers. When you hear someone refer to the top line, they’re often referring to the total revenue. The top line would be how much cash you brought in from selling cinnamon rolls, cups of coffee, and other items if you own a Cinnabon franchise, for example.
What Is the Bottom Line?
The bottom line refers to the last line on the income statement. That last line item is net income. It’s the amount of profit a company has left after paying all of its expenses. When you hear someone talking about bottom line, they’re referring to net income. Revenue would come from the sales of items if we go back to the example of a Cinnabon franchise. The franchise will have expenses to keep the business up and running. One location will have expenses such as wages, rents, utilities, and cost of goods sold. Revenue from the sales will be used to pay these. Net income is what’s left over.
Don’t Confuse EBITDA With the Bottom Line
Another profitability metric is often confused with the bottom line. EBITDA, or “earnings before interest, taxes, depreciation, and amortization,” may or may not show up on an income statement. It depends on whether the company reports EBITDA, but disclosure is not required according to U.S. GAAP. EBITDA is a measure of profitability that differs from net income. Net income is arrived at by subtracting all expenses from net revenues. EBITDA subtracts all expenses except for interest, taxes, depreciation, and amortization. EBITDA may appear as the last line item on the income statement when some companies report it.
Other Lines on the Income Statement
An analyst may be referring to one of three different types when talking about profits. Gross profit refers to the total revenue minus cost of goods sold. Operating profit refers to the total pre-tax earnings from the operating activity. It’s figured by taking the gross profit and removing items that fall into a category known as “selling, general, and administrative expenses.” “Net profit” is another term for net income. When someone refers to “gross profit,” “operating profit,” or “net profit,” they may be referring to the actual figure expressed in a given currency, or they may be talking about a relative financial ratio known as a “profit margin,” which is figured by dividing profit by revenue. The profit margin would be 50% if profit for a business were $1.2 million and revenue were $2.4 million.
Use Profit and Profit Margin for Basic Valuation Analysis
You can go one step further after you’ve figured out the top-line and bottom-line figures. You can use them to perform some basic valuations on companies. One formula for valuing a stock’s growth breaks out three valuation multiples. You can use them to try to compare how “expensive” one stock is versus another, at least on a first-pass basis. The three metrics include the price to earnings (P/E) ratio, which expresses price per share over earnings per share. It can tell you how expensive a company is compared to its net income. You can compare a company’s P/E ratio with the average of its industry to find out whether it’s undervalued or overvalued. The price to earnings growth (PEG) ratio is related to the P/E ratio. It takes the growth in the underlying profits into account, which can help give you a more informed view of a stock’s true value. The dividend-adjusted PEG ratio attempts to factor in not only growth but dividend income as well. Using this ratio can help you compare mature companies to smaller ones.
Relationship Between Top Line and Bottom Line
There are a few takeaways to remember about top-line and bottom-line profit figures. It’s possible for an enterprise to increase the top line (sales) while decreasing the bottom line (net earnings). That can happen when expenses increase at a faster rate than revenues. It’s also possible for an enterprise to decrease the top line while increasing the bottom line. Firms can generate profits through cost cutting, automation, and structure changes within the business. The ideal picture is often one in which the top line and the bottom line are growing in tandem. That shows you that the firm is improving its financial performance and operations in a sustainable way. However, it could be a red flag if revenues and profits are increasing and decreasing in a sporadic fashion.
