Revenue to Net Income: How money flows through a business

In 1936, the high plains of the United States was a disaster.

It was the wake of the Dust Bowl.

10's of thousands of families were abandoning their homes.

Agricultural losses were the current equivalent of $550M dollars per day.

Then, in the late 1940's, a miracle happened.

Desperate farmers used new innovations in water pumps and irrigation systems to give new life to the land.

As water flowed from deep underground, both crops and life on the plains thrived.

But, today, the high plains are in trouble again.

In the decades following the miracle, more and more demand for water sent it flowing to various purposes at increasing volumes.

So much so, that today, some places spend water at 9 times the rate it's replenished.

The impact's starting to be felt, as wells run dry.

Obviously, the situation's not good.

But, the good news is that people are aware and working to address it.

It's an uphill battle, but there's still time to prevent systemic collapse.

There're striking similarities in the way natural ecosystems and businesses transition between states of stress and strength.

Instead of depending on the flow of water, businesses depend on the flow of money.

The flow of money in a business tells us a lot about its health.

And, if we don't pay attention, we'll end up with the financial equivalent of drought and famine.

What we'll cover

We're going to do our best to understand how money flows through a business.

We'll go over:

• Revenue

• Gross Income

• Cost of Goods Sold (COGS)

• Operating Income

• Operating Expenses (OPEX)

• Other Income and Expenses

• Non-operating Income and Expenses

• Income Before Income Taxes

• Net Income

Along the way, we'll see how they apply to an imaginary business called Lemonade Stand Inc. 🍋😃

(As the name implies, the company runs a lemonade stand.)

Revenue

Alternative name(s): "Sales"

Revenue is: All the money a company receives from sales of its products and services.

For Lemonade Stand Inc., Revenue is the money received from selling lemonade.

Let's say the company sold 20 cups of lemonade for $5 per cup. So, the total Revenue is $100.

That's it. This one's pretty simple. 🙂

Note: Sometimes, Revenue is referred to as "the top line". This's because it's the the first line (at the top) of the income statement in a financial report.

Gross Income

Alternative name(s): "Gross profit"

The path money takes through a business has a number of checkpoints along the way.

At each of these checkpoints, some of the money splits off from the main path to fund a specific set of business needs. And the remainder of the money continues on.

Revenue is one of these checkpoints. Some of the money passing through splits off to pay for the production and delivery of the company's products. The rest continues on to the next checkpoint: Gross Income.

So, Gross Income is: Revenue minus the costs of production and delivery.

That is, it's what's left of Revenue after subtracting out the costs of producing and delivering whatever the company sells.

The "costs of production and delivery" are typically referred to as one of the following:

• Costs of Goods Sold (COGS): This term is often preferred by companies that sell physical goods. It generally includes expenses for materials and labor directly used to produce and deliver the goods.

• Cost of Sales: This term is often preferred by companies that sell services. It generally includes expenses directly involved in performing services sold to customers. Though, companies also sometimes use "sales" to refer to sales of physical goods rather than just sales of services.

• Cost of Revenue: Cost of Revenue is a more generic term that's often preferred by companies that sell both physical goods and services.

Regardless of which of these terms a company uses in its reporting, the concept is the same: They represent all the money spent producing and delivering whatever the company sells.

So, in all cases, Gross Income is how much money is left over after covering the costs of production and delivery.

Gross Income helps us get a sense of how good a company is at producing whatever it sells.

For Lemonade Stand Inc., let's say COGS includes:

• $20 for the lemons, water, and sugar that went into the lemonade

• $10 for the paper cups the lemonade was served in

• $10 for the wages of the employee who prepared the lemonade

Taking our $100 of Revenue and subtracting COGS gives us $60 of Gross Income: $100 - $20 - $10 - $10 = $60

Operating Income

Alternative name(s): "Operating profit", "operating earnings"

From Gross Income, some money splits off to pay for "Operating Expenses" (OPEX) and the rest continues on to the next checkpoint: Operating Income.

So, Operating Income is: Gross Income minus OPEX.

OPEX includes expenses that:

1. aren't COGS (i.e. they aren't directly used to produce and deliver goods and services), but

2. are still necessary for the day-to-day functioning of the business

OPEX includes things like:

• Wages for administrative, marketing, sales, engineering, and other non-production employees

• Sales expenses like advertising, promotions, commissions, etc.

• Facilities expenses like rent, property taxes, maintenance, and utilities

• Payments for office supplies

• Payments for insurance

• Payments for legal, accounting, and other business services

Operating Income helps get a sense of how good a company is at operating its business.

For Lemonade Stand Inc., let say OPEX includes:

• $10 for the wages of the employee selling the lemonade

• $10 for the wages of the manager of the business

• $10 to rent the space for the stand

• $5 to place a sign at the end of the street to advertise the business

• $5 paid for research done to improve the lemonade recipe

Taking our $60 of Gross Income and subtracting OPEX gives us $20 of Operating Income: $60 - $10 - $10 - $10 - $5 - $5 = $20

Side note: Sometimes, a term called "earnings before interest and taxes" (EBIT) is used interchangeably with Operating Income. In some cases, they're reasonable approximations for one another. But they're not necessarily equal [1]. We'll discuss what EBIT is in another article, including how it differs from Operating Income.

Other Income and Expenses

Other Income and Expenses are: Any income or expenses a company considers to be [2, 3, 4]:

• Outside its main line of business or

• One-time events

These are separated out from operational income because it makes it easier to see how much income comes from a company's core business and how much comes from other sources.

This is important because a company's core business is what drives its value over the long-term.

At the same time, substantial one-time income or expenses can have a major impact on the business.

Items a company might separate into Other Income and Expenses include:

• Interest income from investments or bank deposits

• Dividend income from investments

• Selling a byproduct of production

• Profits/losses from sales of assets (like unused equipment)

• Income/losses from lawsuits

• Interest expenses from debt

• Income from subleasing unused office space

• Income from refunds or rebates

What any given business includes in Other Income is up to that business. That means that what's included in Other Income varies from company to company.

Looking at a real example, Apple's 2023 annual report (10-K) has a break-out of Other Income and Expenses:

Unfortunately, their list of items under "Other Income" includes an item likewise called "Other Income". 🤔 There's no additional detail about it. Sometimes companies provide more detail about these kinds of things in their quarterly earnings calls.

Anyways, we can at least see interest income and interest expenses separated out.

For Lemonade Stand Inc., let's say Other Income includes:

• $5 for letting someone else sell cookies from the lemonade stand

• $1 in interest from the bank where the company's cash is held

And, other expenses include:

• $2 in interest paid for borrowing $20 to help start the business

The items on these lists are "Other Income" because the lemonade stand's primary business is selling lemonade.

Totaling these items, Other Income is $4: $5 + $1 - $2 = $4

Non-operating Income and Expenses

Alternative name(s): "Incidental income and expenses", "peripheral income and expenses"

Non-operating Income is: Money a company makes from sources other than its primary business activities [3].

Non-operating Expenses are: Money a company spends on business activities that aren't those of its primary business [4].

In general, Non-operating Income and Expenses fall entirely within Other Income and Expenses. This isn't always the case, but exceptions are uncommon.

What about the other way around?

When might a company call something Other Income, but not Non-operating Income?

Imagine a company that makes furniture from wood. Imagine they regularly sell the sawdust from cutting the wood to a charcoal maker. These sales of sawdust would be considered Other Income because they're not part of the company's primary business of selling furniture. However, the sawdust's produced and gathered as part of the company's regular operations. So, the company doesn't consider the sawdust sales to be Non-operating Income. Stated another way, the company considers its sawdust sales to be part of normal operations, but not part of its primary business.

Let's see which of the Lemonade Stand Inc.'s Other Income is Non-operating Income.

The company has $5 of Other Income from allowing someone to sell cookies from the lemonade stand. That came from the normal operational activity of managing the physical lemonade stand. So, the company might not consider it Non-operating Income.

On the other hand, the $1 of interest from the company's bank account would be considered Non-operating Income. This is because the interest didn't come from activities related to making or selling lemonade.

Note: This term doesn't show up in our flow diagrams. But, it's important to cover because it's commonly used.

Income Before Income Taxes

Alternative name(s): "Income before provision for income taxes", "income before taxes"

Note: "Income before provision for income taxes" includes the word "provision" to be as explicit as possible that the referenced tax amounts include all taxes owed on the income, whether paid yet or not.

Income Before Income Taxes is: The sum of Operating Income and Other Income.

That is, it's the sum of income from the company's primary business, plus any income from other sources.

It's "before income taxes" because, even though all expenses have been subtracted out, we still need to account for income taxes.

(Once we subtract out income taxes, we'll finally arrive at Net Income.)

For Lemonade Stand Inc., Income Before Income Taxes is $24: $20 of Operating Income + $4 Other Income = $24

Net Income

Alternative name(s): "Earnings", "net profit", "profit"

Net Income is: Income Before Income Taxes minus Income Taxes.

This is a company's final profit.

That is, it's the amount of income remaining after all expenses and taxes have been subtracted out.

Let's say Lemonade Stand Inc.'s tax obligation is 21%. The company's Income Before Income Taxes is $24, so that gives us:

• Income Taxes of $5.04: $24 × 0.21 = $5.04

• Net Income of $18.96: $24 × (1 - 0.21) = $18.96

Note: Sometimes, Net Income is referred to as "the bottom line". This's because it's the last line (at the bottom) in the income calculations in a company's income statement.

Putting it all together: Lemonade Stand Inc.

If Lemonade Stand Inc. issued a quarterly report (10-Q), it'd include an income statement that looks like this (minus the notes on the right):

It's a different way of looking at the things we've discussed, but all the concepts are there.

Here's another view of how money flows through Lemonade Stand Inc.:

We don't find these kinds of images in typical financial reports.

But, they're still useful for getting a feel for how money's flowing through a business.

Putting it all together: Apple Inc.

Here's a real income statement from Apple. It's from their Q3 quarterly report (10-Q):

They're using some alternative names for terms. But, they have the same meaning:

• Total net sales → Revenue

• Total cost of sales → COGS

• Gross margin → Gross Income

• Total Operating Expenses → OPEX

• Other Income/(Expenses), net → The sum of Other Income and Expenses

• Income before provision for income taxes → Income Before Income Taxes

• Net Income → Net Income

Here's a visualization of the flow of income:

Here's another version of the same image. But, this time it includes percentages whenever there's a fork in the path:

And, here's one more. In this one, we normalize all the values to Revenue + Net Other Income. That is, show all values as a percent of Revenue + Net Other Income:

There're a lot more ways to think about the relationships between the terms we've been looking at.

We'll spend more time on this in future articles.

Putting it all together: Tesla, Inc.

Here's a real income statement from Tesla. It's from their Q2 quarterly report (10-Q):

And, the visualization:

Looking at how money flows through Tesla, we can see it's business is really different from Apple's!

Even if we couldn't see the companies' names, we could probably guess that they're in different industries.

Formulas

Here's a summary of the formulas:

Gross Income = Revenue - Cost of Goods Sold (COGS)

Operating Income = Gross Income - Operating Expenses (OPEX)

Income Before Income Taxes = Operating Income + Other Income and Expenses

Net Income = Income Before Income Taxes - Income Taxes

Conclusion

Just like communities need to monitor the flow of water in their ecosystems, we need to monitor the flow of money in businesses we invest in.

They reflect how well companies are managing their resources.

And they tell us a lot about the health health of their business.

Next time, we'll go over "cash flows".

Wait... but didn't we just go over cash flows?

Not quite. We went over the flow of income, not the flow of cash.

What's the difference between income and cash?

Great question. 😉

Until next time, happy hunting!

References

Noted references:

1. Operating Profit vs. EBIT: What’s the Difference?. Indeed Inc. Retrieved 2024-08-26.

2. Noah Gomez. Other Income: Definition, Detailed Examples & Negative OI. Analyst Answers. Retrieved 2024-08-23.

3. Non-Operating Income. CFI Education Inc. Retrieved 2024-08-23.

4. Non-Operating Expense. CFI Education Inc. Retrieved 2024-08-23.

References related to water availability in the high plains of the United States:

• Jane Braxton Little. The Ogallala Aquifer: Saving a Vital U.S. Water Source. Scientific American. Retrieved 2024-09-28.

• David Condos. With the Ogallala Aquifer drying up, Kansas ponders limits to irrigation. Kansas City Public Radio. Retrieved 2024-09-28.

• Ryan Hanrahan. Ogallala Aquifer Depletion Threatening Rural Communities & Ag. University of Illinois at Urbana-Champaign, Department of Agricultural and Consumer Economics, Farm Policy News. Retrieved 2024-09-28.

• Ogallala Aquifer. Wikipedia. Retrieved 2024-09-28.

• Dust Bowl. Wikipedia. Retrieved 2024-09-28.

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