The two sections of the income statement, or profit & loss (P&L) statement, of a company
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The top line and bottom line are two sections of the income statement, or profit & loss (P&L) statement, of a certain company.
The top line item on the income statement refers to a company’s gross sales or total revenue and the bottom line, which is often listed at the end of the income statement, is the net income (also be referred to as net earnings or net profits) generated by the company after deducting the cost of goods sold (including direct labor and materials), general and administrative costs, depreciation and amortization charges, interests, and taxes.
The bottom line of a company is not carried over from one period to the next on the income statement from an accounting standpoint. At the end of the accounting year, upon the closing of all revenue and expense accounts, the net account balance, or the bottom line, is transferred to the retained earnings account.
The income statement, or profit & loss (P&L) statement, is one of the three most important financial statements used for reporting a company’s financial performance over a specific accounting period. It essentially focuses on the company’s revenues and expenses during a particular period.
The top line, which is part of the income statement of a company, refers to the gross sales or total revenue of the company.
The bottom line, which is the item that gets listed at the end of the income statement, is the net income generated by the company after deducting the operating expenses, depreciation, interest, and taxes.
If the ratio of the company’s earnings growth to revenue growth diverges a long way from “1” for a prolonged period, that should be a warning sign as its strategy to generate future profit growth is probably decaying.
Understanding the Top Line and Bottom Line Figures
Net Income (or Bottom Line) = Gross Sales (or Top Line) – Total Expenses
Top-line and bottom-line figures are useful in determining the financial strength of a company; however, they are not interchangeable. While the bottom line describes how efficient a company is with its spending and operating costs, the top line does not take into consideration operating efficiencies and only indicates how effective a company is at generating sales.
Companies can increase their top line through engaging in aggressive advertising to gain new customers, adding new product lines, lowering sales returns through product improvement, or increasing prices.
Conversely, they can increase their bottom line through cost reduction – lowering the cost of materials, operating out of less expensive facilities, utilizing tax benefits, limiting the cost of capital, etc.
The most profitable companies typically experience both top-line and bottom-line growth simultaneously by earning more revenues (top line) and reducing their operating costs (bottom line). However, established companies might have flat sales or revenue during a particular period but are still able to boost their bottom line through cost-cutting measures.
For example, in 2019, Apple Inc. recorded lower-than-expected iPhone sales and posted a top-line revenue number of $260.2 billion – down from the previous year’s revenues of $265.6 billion. In the same year, its bottom-line number was $55.3 billion, which was smaller than the $59.5 billion it recorded in 2018.
A company like Apple might experience sluggish sales and, consequently, weaker top-line growth due to maturing products, lack of new products, and supply constraints. A fall in the top line will often feed through to the bottom line, leading to a smaller net profit.
Divergence between Top Line Growth and Bottom Line Growth
The divergence between earnings growth and revenue growth is quite common in companies, particularly mature companies, at least over short periods. Due to a sharp decline in input prices or strict cost control measures undertaken by companies, profits can grow much faster than revenues.
However, only a few companies are in the position that they can go on getting price increases over and above the inflation rate in their revenues year after year. There’s always a limit to how much profit even the most efficient company can squeeze out of any fixed amount of revenue.
Therefore, if a company’s revenue growth has been consistently falling behind its profit growth, its capacity to generate future profit growth will be in deep decay.
The same remains true if the profit growth is slower than the sales growth year after year. To put it differently, if the ratio of the company’s earnings growth to revenue growth diverges a long way from “1” for a prolonged (say five to seven years), it should be a warning sign as its strategy to generate future profit growth is probably decaying and looks doubtful. The value potential of the company’s strategies is just about spent, and there are problems around the corner if the ratio consistently diverges by a large margin.
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