What it means
Earnings sit at the very bottom of the income statement, after revenue has absorbed the cost of goods sold, operating expenses, interest and tax. Everything above that line describes activity; the earnings line describes what the owners actually kept.
Earnings matter because they are the pool of money a company can reinvest, use to repay debt, or hand to shareholders as a dividend. They also drive share prices through the price-to-earnings multiple, which is why listed companies discuss them so intently.
A business can grow revenue for years and still be worth very little if earnings never follow. In practice the figure gets sliced several ways.
Earnings per share divides it by the number of shares outstanding so investors can compare companies of different sizes, while retained earnings track the cumulative amount kept inside the business rather than paid out. Be careful with any adjective sitting in front of the word.
Adjusted earnings, underlying earnings and normalised earnings all strip out items management considers one-off, and while that can be genuinely helpful, it is also where optimism tends to creep in. Timing rules also shape the number in ways that surprise newcomers.
Revenue is recognised when it is earned rather than when the customer pays, and large costs such as equipment are spread across several years as depreciation, so earnings describe a period's economic performance rather than its bank movements. Finally, earnings are an accounting measure, not a cash measure.
A company can report healthy earnings while cash drains away into unpaid invoices and new inventory, so always read the cash flow statement alongside the earnings line.
In practice
Real-world examples.
Example
A regional bakery chain reports revenue of $12,000,000 and earnings of $360,000, a 3% net margin. The owner uses the earnings figure, not revenue, to decide she can afford one new site rather than three, because only the $360,000 is genuinely hers to redeploy.
Example
A software company posts its first positive earnings after six years of losses. The number is small at $220,000, but the board treats it as the milestone that lets them stop raising dilutive equity and start funding growth from the business itself.
Example
A logistics firm shows flat earnings year on year despite revenue rising 18%. Digging in, the finance director finds fuel and driver pay rose faster than freight rates, so all the extra revenue was absorbed by cost before it ever reached the bottom line.
Formula
Calculation
Earnings = Revenue - Cost of Goods Sold - Operating Expenses - Interest - Tax
Take an equipment distributor with revenue of $4,000,000 for the year. Cost of goods sold is $2,200,000, leaving gross profit of $4,000,000 - $2,200,000 = $1,800,000. Operating expenses of $1,100,000 bring operating profit to $1,800,000 - $1,100,000 = $700,000, and interest on the bank loan takes another $100,000, giving earnings before tax of $600,000. Tax at 25% is $600,000 x 0.25 = $150,000, so earnings are $600,000 - $150,000 = $450,000. With 900,000 shares outstanding, earnings per share is $450,000 / 900,000 = $0.50.Case study
Seen in the real world.
Harborline Instruments is an illustrative, entirely fictional maker of laboratory scales. In its third year the company celebrated revenue of $9,000,000, up from $6,000,000, and the founders began planning a warehouse expansion on the strength of that headline.
The finance manager walked them down the income statement instead. After cost of goods sold of $5,400,000, operating expenses of $3,000,000, interest of $200,000 and tax of $100,000, earnings came to $300,000. That was less than the previous year's $340,000, because the company had bought growth by discounting heavily and hiring ahead of demand.
The board postponed the warehouse, raised prices on two low-margin product lines and cut discretionary spend by $250,000. Revenue grew more slowly the following year, but earnings roughly doubled, and the expansion was funded from the business rather than from a new loan.
Watch out
Common mistakes.
- Treating earnings and cash as the same thing. Earnings include non-cash items such as depreciation and revenue billed but not yet collected, so a profitable business can still run out of money.
- Comparing adjusted earnings from one company with reported earnings from another. The adjustments are chosen by management and are not standardised, so the two figures are not on the same basis.
- Assuming rising revenue automatically means rising earnings. Cost growth can outpace sales growth easily, leaving the bottom line flat or falling while the top line looks excellent.
Questions
People also ask.
Are earnings the same as profit?
Broadly yes, but "profit" is used loosely for gross profit and operating profit too, whereas earnings almost always means the after-tax figure.
Why do investors care about earnings per share rather than total earnings?
Because per-share earnings adjust for how many claims exist on that profit, so a company issuing lots of new shares cannot flatter its numbers simply by getting bigger.
Can earnings be negative?
Yes, and a negative figure is simply a net loss for the period, which is common for young companies investing heavily ahead of revenue.
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