For a great many business owners, an increase in revenue is one of the most obvious signs that a business is doing well. Having more customers, generating more sales and achieving a higher turnover are certainly positive indications.
From the point of view of an accountant, however, revenue makes up only part of the whole story.
A company can achieve a substantial rise in its revenue even if its profit decreases, or in some cases makes less profit than before. It is important to understand the reason for this in order to make well-informed decisions and to make certain that growth actually improves the financial position of the business.
Revenue Is Not the Same as Profit
The income that a business obtains by selling its products or services is known as revenue, and profit is the amount left after the costs associated with producing that revenue have been subtracted.
In simple terms:
Revenue – Expenses = Profit
It is possible for this distinction to be overlooked when companies place a strong emphasis on sales targets.
For example, suppose a business raises its annual revenue from $1 million to $1.3 million; on the surface the 30% increase appears impressive.
On the other hand, if the wages, rent, the cost of materials, software, marketing, freight and all other operating expenses have risen at a faster rate, the business could end up with a smaller profit margin.
Retention should therefore be judged not just on the amount that you sell but on the amount that you retain.
The Hidden Cost of Growth
Growing can be a costly affair.
When sales go up, companies usually have to put money into more staff, more equipment, larger premises, more technology, greater inventory and more marketing.
For instance, a business which secures a number of major contracts might have to hire more staff in order to deal with those contracts. In this case, if the contracts were obtained by providing greatly reduced prices, the extra revenue might not yield the anticipated amount of profit.
Just as a business involved in retail or manufacturing might see rapid growth in sales it will need considerably more stock and working capital to back that growth.
This is why accountants often look beyond the headline revenue figure and ask:
What was the cost to the business of producing that extra revenue?
Profit Margins Matter
A very useful way of measuring business performance is the profit margin.
Consider two businesses:
Business A has a revenue of $2 million and a profit of $400,000.
Business B has a revenue of $3 million and a profit of $300,000.
Although Business B has a higher revenue, Business A is making a considerably greater profit.
That is the reason why a rise in revenue should not be regarded as a success if the profit margins are falling.
A business that is growing should preferably keep an eye on both revenue growth and margin performance.
Discounting Can Increase Sales but Reduce Profit
Another frequent reason why revenue growth does not result in higher profits is discounting.
Cutting prices can be an effective way of drawing in customers, gaining more market share or getting rid of surplus stock. The problem is that companies have to consider the effect that discounts have on their profit margins.
For example, where the price of a product is $100 and its production cost $60, the gross profit will be $40.
If the business reduces the price of the product to $80 then revenue could go up since more customers will buy it; the gross profit per sale has however dropped from $40 to $20.
The company would have to sell twice the number of products if it was to achieve the same gross profit.
In terms of accounting, sales growth should be looked at together with the gross margin.
Cash Flow Can Become a Problem
It is also important to note that profitable growth may still have an effect on cash flow.
A company might have strong sales yet its customers could take 30, 60 or even 90 days to pay their invoices. In the meantime the business would have to pay its suppliers, employees and other expenses much sooner.
With increasing sales, the sum of money tied up in accounts receivable and inventory may also go up.
It means that a company can be making a profit in theory even if it is facing cash-flow problems in its bank account.
Growth can therefore only be achieved by giving attention to profitability, working capital and cash flow, not merely to revenue.
Not All Revenue Is Equal
It is likewise important for an accountant to know where the revenue is arising.
In certain cases the margins on products or services will be much higher than in other cases, and some customers may prove to be profitable to serve, while others may demand a lot of time, support or have to be given discounts.
A company which increases the revenue from its low-margin items while ignoring its high-margin products could in fact end up being less profitable as it grows larger.
That is the reason why examining revenue according to product, service, customer, or business division can yield valuable insights.
The question isn’t simply:
How much money did we bring in?
It is:
What was the source of revenue that gave the business the highest return?
The Importance of Understanding Your Numbers
Owners of businesses needn’t become accountants but should understand the key figures that drive their business.
At a minimum, I recommend regularly monitoring:
Revenue growth
Gross profit and gross profit margin
Operating expenses
Net profit and net profit margin
Accounts receivable
Inventory levels
Cash flow
Debtor payment times
Revenue and profitability by product or service
Considering the figures as a whole gives a considerably clearer picture than concentrating merely on turnover.
Sustainable Growth Is the Real Goal
Revenue growth can be exciting and is certainly a significant indicator of how well a business is performing. Yet greater growth doesn’t necessarily mean that it’s better.
The most successful businesses are not merely the ones that achieve higher sales; they are those which are able to increase their revenue while at the same time keeping their margins healthy, controlling their costs, managing their cash flow and earning sustainable profits.
As an accountant, I would encourage business owners to look beyond the headline revenue figure and ask three simple questions:
Are we growing?
Is our growth profitable?
Is the cash that we are generating sufficient to support the business?
In the end, the aim is not merely to create a larger business.
The aim is to create a financially sound and sustainable one.
If your revenue is increasing but your profits are not keeping up with it, then you should consider going beyond the sales figures and investigate what is actually responsible for the performance of your business.