Knowledge Centre
Revenue or Sales Revenue or Turnover
Revenue, or sales revenue, is the income a business derives from its normal activities. Also referred to as Sales or Turnover or Top Line, it is the first number on an income statement. Income is essentially the money or payment received for that company’s activity or service. It may also include money earned from other sources such as deposit interest, investments, fees and royalties.
Normally we look at revenue over a fixed period-of-time; monthly, quarterly or on an annual basis.
Revenue is the single most important aspect of a business and the financial analysis of that business. It is the first number to look at. The revenue number is required to calculate many operational, efficiency and profitability ratios. Examples include, but are not limited to, profit margin, return on capital needed to generate that income and employee productivity, or return on employee.
In a perfect world this revenue should equal the cash received. You sell something, you get paid. With this type of activity simple, you would use a cash basis of accounting. You make the sale and the cash hits the company bank account.
But what if you sell something and the agreement is that the business gets paid 30 days later. What if it takes the company 30 days to make, and/or deliver, a product or service? Buyers will only pay on receipt of that product or service. Let’s say they want 30 days to pay. This arrangement is known as the Terms of Trade and Conditions of Sale, typically in the form of a legally binding contract. In this particular case, the company would record the sale which would be added to the total Sales Revenue number, even though it has yet to be paid. This is known as Accrued Revenue on the basis of Accrual Accounting.
For some businesses, as with individuals, the product or service will not be delivered without payment first or “up front”. This payment may be “in full” or part, “deposit”. This is known as Unearned Revenue or Deferred Revenue or Customer Deposits. So, the money has been taken, or part of, but we have yet to deliver. We have still to take the costs associated with delivery. We owe the customer. So, in a way it’s a debt. To know the true position or financial health we need to recognise this. Otherwise we would be overstating. This is recorded in the Liability Account, as Notes Payable, Customer Deposits, Unearned Revenue or Accounts Payable. On delivery of the good or service, this record is removed from the liability account.
The two above examples are known as Revenue Recognition. The critical question to ask is: ‘when was the actual revenue earned’? To be able to compare similar businesses, doing similar things, on similar Terms of Trade, we need to be able to standardize how we report and record these Revenue Recognitions.
That’s why we have Generally Accepted Accounting Principles (GAAP) based in the United States and established in 1973. It has detailed rules how and when revenue is reported and recorded. You often see GAAP in financial analyst reports. It means the reader knows the rules. US law requires all publicly trade companies to follow GAAP as part of Securities Act of 1933 and the Securities Exchange Act of 1934.
To complicate matters there is another “standard”. We have the International Financial Reporting Standards (IFRS). This is administered by the International Accounting Standards Board (IASB), based in London and established in 2001. IFRS is a set of principles or guidelines. The most recent version is known as IFRS 17. IFRS standards are required in over 140 jurisdictions including EU member states, South Africa, Australia and Singapore/Hong Kong.
In a nutshell, GAAP is rules-based, and IFRS is principles-based. But the analyst needs to be familiar with the differences when analyzing a company set of financial statements. The Revenue Recognition method is explained in the Notes to Consolidated Statements at the end of the Report and Accounts.
Important, we can now understand that revenue is NOT profit. It is NOT always cash.
Manipulation or “cheats”. Be sure to approach the financial statements and a clean bill of health from the auditors (the accountants to the company) with skepticism and an inquisitive mind.
Recommended reading in our Library, “The Signs Were There: The clues for investors that a company is heading for a fall”, Tim Steer.
Tim’s analysis of Aston Martin and Patisserie Valerie, amongst others, are fascinating. There are a multitude of different ways a company can manipulate revenue or financial statements, while staying within the prescribed rules, and receiving auditor sign off. By the way, the auditor is paid by the company. Microsoft pays over $46 million in audit fees every year. Impartiality?
None of the so-called Big Four – EY, KPMG, Deloitte and PwC – managed to surpass the 90 per cent target of its audits being assessed as good quality, the accountancy watchdog said.
The results come after a string of high-profile cases in which auditors missed potential financial problems or fraud – including signs of trouble at Carillion, BHS and Patisserie Valerie. This was according to the Financial Reporting Council in 2019.
You might want to inflate the Revenue to artificially boost the value of your business. You might want to inflate because your salary or bonus is directly calculated from the revenue number, or from revenue growth. In publicly traded companies, commonly company executives and managements have share priced-linked incentive plans such as Stock Options schemes. A company may wish to raise capital quickly or take over a competitor but lack sufficient balance sheet strength. Inflating the revenue and associated financials will help.
Fact: “Tesla agreed to sell Elon Musk nearly 1.69 million shares of Tesla stock at a price of $350.02 each once he led the company to a sustained $100 billion market capitalisation and hit other milestones”. That’s $726 million. Tesla to date has never made an annual profit. In 2019 it lost a reported $862 million. Thus far it has never paid a dividend.
Here are some examples of “cheating”. There are many forms, or schemes.
- “Channel stuffing”. You ship or deliver more typically goods or services to distributors and retailers in your distribution channel than they are likely to sell. See Tim’s example of Aston Martin. You either use financial inducement such as discounts, or the terms of trade allow the right to return any unsold after a period of time. It catches up in the end.
- “Grossing up”. This is where the company is recording the entire sales value when actually it is only acting as agent. A company sells a product or service, which is part, or totally, provided by an unrelated supplier. However, the company recognises the total sale despite ultimately having to reimburse the supplier.
- “Barter and Round Tripping”. Here, say, two companies swap (barter) products or services of a similar nature. But the reality is there is an unrecognized cost, and therefore a revenue effect. A good example of this would be two companies engaged in selling advertising space. Company 1 sells (swaps) its available ad space to Company 2 in exchange for the right to advertise on Company 2's space. These can be for television rights, internet advertisements, radio rights, actual billboards or various other types of media. “Round Tripping” has similarities. Here, cash is involved. Company 1 sells Company 2 a product or service for cash, while Company 2 sells to Company 1 an equivalent or similar amount as the first transaction.
- “Non – Recurring Revenue”.
- “False Revenue”. In other words, fraud. The recording of artificial sales. Plain and simple.
If you are a private company, you may wish to pay less tax. Reported financials are not relevant. Lowering the reported revenue to lower reported income equals less tax payable.
Alternative ways to look at revenue:
Revenue = Cash Sales Collected + Changes in AR (Accrued Revenue)
All well and good, but revenue can still be inflated or manipulated if desired.
Perhaps one of the best ways to work out what’s going on is the Number of Days (Sales) Outstanding (DSO) ratio. This being for a period;
DSO = Ending Receivables/Revenue x numbers of days in period
This will tell us how many days it takes to collect the revenue after a sale. If this number goes up, either sharply or consistently, it may mean the company is unable to collect payment or is aggressively incentivizing buyers. It could also be disguising structural sales weakness.
At TEAM we look to invest in true revenue growth companies. But our stringent investment criteria include a host of additional characteristics and ratios that companies must meet, such as net profit, return on WACC, Debt, Dividends and not least, our 12 Rules. We also observe trends across metrics, for example, Revenue Growth versus Earnings Growth. Are those additional sales proportionately reflected in the profit line?
Why is Revenue growth important? Because it is an indication the market’s the company operates in are growing. We look for companies whose revenue is growing ahead of the market, sector and Global Economy (GDP). It is a demonstration of the company’s competitive advantage or strength. Normally this means financial strength and most often the company benefit from a repeat purchase characteristic. It may also demonstrate good- to-excellent management, culture, inventiveness, research and development, customer loyalty and entrepreneurialism.
So, at TEAM we look for 10% growth per year or more over extended periods of time. This is demanding unless there is a big market opportunity. We are not concerned with which country or geographic region, but it must be growing. These companies can survive and thrive in tough economic times. They can generate robust shareholder returns over long periods of time.
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