As the COVID-19 pandemic shows little signs of stopping, many have rushed to find a new hobby or monetary source. Trading can meet both criteria, and thus many found it alluring and decided to try their hand at it. And if you’ve ever tried to pick up a new skill or hobby, you must be familiar with the feeling of wanting to progress quickly. However, that same feeling often causes people to rush through, sacrificing fundamentals.
In the trading world, that translates to misunderstanding relatively basic concepts. That can lead to difficulties further down the line, especially if traders decide to move on to more serious literature. One of the more common mistakes people make is mixing up revenue and profit.
The two terms represent relatively similar things, and as such, people who didn’t devote time to familiarizing themselves with the terms in more detail use them interchangeably. However, to understand economic language, we must know the exact meaning of the words we’re using. While profit and revenue do share some things, each has distinct boundaries that separate it from the other. Today we will inspect those terms in hopes of clearing up any misconceptions.
Also called the top line, revenue is the income of a company before deducting any expenses. It’s earned its nickname as you can find it near the top of the income statement. However, that doesn’t mean all the money a firm manages to make can be considered revenue. To clarify, we’ll use a furniture shop as an example.
If the furniture shop sells $1 million worth of its wares, its revenue also equates to $1 million. But let’s say that same company has a subsidiary that only sells home decorations, which made $10,000. And let’s also assume the furniture shop made $100,000 from investments. When you add all that up, you end up with $1,110,000, so that’s what the revenue should be, right?
That’s precisely the most common misconception people hold. In the above example, only the first $1 million should be considered revenue, with the rest being accounted for distinctly.
Profit is a more realistic showing of how a company is performing. Also called the bottom line, or net income, there are different variations you can use as a baseline for a firm’s operational success. Some care about top-line profitability, while others prioritize profitability before taxes and certain expenses. However, most focus on net profit, which comes after all costs come out.
But what does profit represent exactly? On income statements, it has three aspects, gross, operating, and net profit. Each of these represents a different thing, so let’s look at each.
Gross profit is the first and most basic level of profitability. It follows a simple formula of total sales subtracted by the cost of goods sold (COGS). On an income statement, it’s just below the first line, with COGS right under it. So, for a firm with $60,000 in total sales and a COGS of $40,000, the gross profit is $20,000.
Moving on to something slightly more complicated, we have the second level of profitability or operating profit. While gross profit only needs to take direct expenses into account, operating profit also includes operating expenses. Those include things such as rent, utilities, payroll, selling, and administrative costs. Once you calculate the operative expenses, you subtract them from the gross profit, and you get operating profit.
The third and final profitability level is net profit, which is the most accurate representation of a firm’s earnings. To get the exact net profit number, you need to calculate operating profit, then subtract all expenses that haven’t been accounted for. That includes things such as taxes and interest. Overall, each profitability is lower than the previous, and you need to move through the earlier levels to reach net income incrementally.
Revenue vs. Profit Although the difference between the two terms should be clear by now, let’s reiterate. Revenue is the raw form of a company’s profit, demonstrating the direct income the firm managed to rake in. When people mention profit, they usually mean net profit rather than the other two types. It represents a more precise estimation of a firm’s success, showing exactly how much a company earned after it paid for everything it needed to. We should also emphasize that profit doesn’t need to be positive, regardless of revenue.