Revenue vs Profit: How It Works & Why More Sales Can Mean LESS Cash
Posted on: 05 Nov, 2019
Revenue vs Profit!
It's the difference between how much you money make and how much you actually take home.
Not noticing this huge difference has led many founders to jump into ventures with unrealistic expectations of returns on their time and money invested.
In this article we will:
Table of Contents
It all starts with income and we break it down from there.
Income refers to all the money that the business makes and it is divided into 2 types.
Operating income: which is the money made just from the sales of products and services
This is called Revenue.
And Non-operating income: which is the money generated from sources other than your sales.
So things like:
Investments, interest, renting out a space in your office etc. These would not be classed as revenue.
This income is what appears at the top of your Income Statement and is intended to show you immediately the money coming into your business.
Why are these forms of income separated?
Why not just bundle it all together simply as income?
The reason for separating these on the income statement is that it provides clarity on your strategy and revenue models that the business is using.
You'll be able to see which channels are more profitable than others, which are not and you can make your business decisions accordingly.
Have a look at Amazon's Income Statement below.
You'll notice revenue right at the top (hence why you hear the term "top line revenue") followed by COGS.
Let's unpack revenue a little further.
Revenue is calculated it by multiplying the sales price of your product with the number of products sold.
As with income there are 2 groups here also:
Gross Revenue i.e. all the money generated from sales.
And Net Revenue i.e. all the money generated from sales after reducing discounts, refunds/returns etc.
You're an e-commerce startup and you sold 1000 products at a sales price of $100.
Gross revenue is: $100 x 1000 = $100,000
However, 200 customers returned the product so you refunded the money.
$100 x 200 = $20,000 was returned.
Your Net revenue is: 100,000 - 20,000 = $80,000
Take a look at Lyft's revenue history below.
They had Q2 revenue of $867.3 million. And an estimated $3.2 billion revenue for the year of 2019.
Here's the catch.
Their earnings (profit) before interest, tax, debts and amortization (EBITDA) for 2019 is estimated to be:
$ -830 million
Yes that's a loss of $830 million.
Source - Taken From Lyft Investor Page
This is not to bad mouth Lyft but to prove that generating revenue and making profit are not the same thing.
With that cleared up, we can jump into profit.
In it's simplest terms:
Profit is the money remaining after all expenses have been paid and it is broken down into 3 types.
In the book, Ready Fire Aim by Micheal Masterson, he explains a further form of calculation for startups to ensure you remain within the lines of profitability.
Assuming you know the profit margin you want from your business you can add that into the mix to also calculate your maximum customer acquisition cost.
Here's what that means in numbers so that it makes more sense:
Let's say you're an e-commerce business and you have a product that has a sale price of $100.
Assuming your cost to produce the product (COGS) is $50 that leaves you with a Gross profit margin of $50 (100 - 50 = 50 i.e. a 50% Gross Profit Margin).
If your overhead is 30% of your sales price that means you have 30% of 100 which is $30 to spend per sale on operating expenses like rent, salaries, bills etc.
And you are left with $20 as your net profit right? ($50 gross profit - $30 operating expenses)
Let's say the average industry net profit margin for your e-commerce business is 15% of the sales price.
That means that your take home amount is $15.
The last remaining $5 is what's called your Allowable Acquisition Cost (AAC).
This is the amount that you can spend to acquire a customer and still build a profitable business.
It also fits with the 3:1 ratio of LTV to CAC for an optimally running business. More on that here.
And therein lies the financial shock for founders that havn't thought about their numbers in this way.
A false sense of security that selling the $100 product means $100 in their pocket when in fact it's actually just $15.
Take a look at these industry averages for profit margin and see if your business is within the range.
Sure you want to have high profit margins but keep in mind that means reducing one or more of the cost of goods sold (COGS), Overheads or AAC.
Here are a few examples for how you can start to think about calculating profitability works.
Let's say you provide an enterprise product and you have agreed Net-30 payment terms with customers.
We all know about the struggle with late payments right?
Here's what it boils down to:
You have a product costing $1000.
With a Gross profit margin of 40% = $400 and Net Profit of $200.
Then they don't pay you within the agreed 30 day period.
Someone from your team has to then call, talk to, email and keep chasing them every week for the next 90 days.
That totals to about 6 hours of work.
At $20 an hour for the employee doing the chasing around that's an extra $120 expense.
Which eats your net profit from $200 - $120 to $80. In other words, from 20% to 8%.
Making the business with them not even worth it.
See how profitability proves that you'd need to ditch that client?
Sales are great but your business lives on cash flow and profitability.
Too many clients like these and you'll be out of business real fast.
This is interesting!
Let's say your startup sells an Enterprise product and you expect an increase in revenue (sales) by $100,000. Whoop Whoop!
If you're not prepared for that growth, you'll soon be in an unpleasant situation.
Sales have a cost and you need the cash to handle those costs.
If you're profit margin on your product is 45% then your cost of goods sold (COGS) will be 55% i.e. $55,000.
Add the overhead expenses for these sales say another $20,000 for increasing sales support, software upgrades, extra engineers etc.
And you'll see that it costs you $75,000 to generate $100K in sales.
Which is a cost of $205.5 per day (75,000 / 365).
If your agreement with the customer is payment within 60 days, this means that you'll need:
205.5 x 60 days = $12,330
Plus a 15 days safety net for delayed payments = 205.5. x 15 = $3,082.5
Total = $15,412.5
This is the amount that you'll need in cash to cover expenses for the sale until you receive payment.
This is a powerful concept for business.
Hopefully you're in the fortunate situation that business is booming and you want to add a new hire.
Calculating that your new recruit costs $50,000 per year is only half the process.
As mentioned earlier salaries are paid from your gross profit margin and specifically your operating expenses (overhead). Let's say your overhead margin is 25% of sales price.
Then you will need to generate additional revenue (sales) of:
50,000 / 0.25 = $200,000
And that's just to cover cost of your new hire while still remaining profitable on each sale.
A firm grasp of the difference between revenue vs profit and how they function is one of the foundational elements for growing your business.
Especially in the early days of your venture when cash is tight you need to protect it and spend it wisely.
This will give you clarity with your decision making to ensure that the actions you take don't jeopardize your profitability.
Sales are good but your business lives on cash flow and profit.
So get a feel for your numbers.
It's all in the numbers
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