When you’re operating a small business, you have to be familiar with all the aspects of running a business, not just what your business actually does or sells. You could be running a cleaning service, operating a food truck, or working as a freelance editor … whatever your business may be, it’s likely that you’re also the accountant, marketing manager, and even receptionist all rolled into one.
One of the more important documents you’re expected to prepare is your company’s financial statements, which are often audited to ensure accuracy and for tax purposes. Your business’s income statement, which focuses on revenue, expenses, gains, and losses over a specific time period, is one of three documents that form the financial statements. (The other two are the balance sheet and the cash flow statement.)
If you’re not an accountant or are unfamiliar with accounting principles, preparing an income statement can be a confusing affair. This article will give you the basic information you need to create an income statement, which begins with answering the question, “What is revenue?”
What Is Revenue?
A company’s revenue is the total income earned as a result of normal business activities, which is usually from the sale of goods or services. In accounting terms, it’s the top line (because it sits on the top line of the income statement) or gross income of the company. Revenue can also be referred to as sales or turnover — the total amount of money earned from the business’s primary activity.
It’s important to note that the total revenue of a company doesn’t include any operating expenses, but does make allowances for discounts and deductions for any returned goods. So when a company is experiencing a high turnover rate, it simply means their net sales number has increased. It doesn’t actually take into account how much they’ve spent to run the business.
When you deduct all the expenses of running the business, including employee wages, rent, and the cost of producing the goods that are being sold, you’ll arrive at your company’s net income or net profit figure: the bottom line.
Types of Revenue
Now that you’ve gotten a clear answer to “what is revenue,” let’s move on to explaining the different types. There are two general types of revenue a company may receive: operating revenue and non-operating revenue. Both make up the total revenue income.
This is derived from a company’s primary activity and is often referred to as sales revenue. At its most basic, revenue can be calculated using the very simple formula of multiplying the number of units sold by the per unit price.
Sometimes, companies may have secondary sources of income, such as interest, royalties, or other fees. Non-operating revenue can also be infrequent or non-recurring.
The Difference Between Revenue and Income
If you’re not an accountant, just knowing the answer to “what is revenue” isn’t enough as it’s likely you’ve used the terms revenue and income interchangeably. In business speak, revenue is very different from a company’s income.
While your revenue may tell you just how well your company is doing in terms of sales, it doesn’t actually take into account any associated costs. This means that you could in fact be running at a loss without even realizing it if you’re only taking your company’s revenue account into consideration.
In contrast to revenue, which sits on the top line of an income statement, the income can be found on the bottom line. In between the top and bottom lines are all the costs and expenses that come from running a business. If you simply deduct the cost of goods or raw materials from your earnings, you’ll arrive at your gross profit or gross margin figure. When you add in other costs, such as marketing, wages, and rent, you’ll get your company’s net income or net profit figure (assuming you’re not running at a loss).
The income of a company is generally more important than the revenue (even though one has an impact on another) as it provides a quick overview of the company’s profitability and viability.
To generate top line growth, you could launch a new service or marketing campaign. To encourage bottom line growth, you’ll need to investigate cost efficiencies or a cheaper supplier.
How to Calculate Revenue
While it may seem straightforward, there are actually a number of accounting methods that can be used to calculate revenue. Some methods include sales made on credit, while others only include any earnings where money has actually been received. The method you use will also impact on your other financial statements: the balance sheet and the cash flow statement.
Cash Accounting Method
This is by far the simplest and most direct way of calculating revenue. Sales is counted as revenue when payment — cash — has been paid for a particular good or service. So as money physically comes into the company, revenue is recorded. This means there are no earnings until your customer pays, even if they may have already received the goods or service, or have been provided with an invoice.
The same principle applies for expenses: When you receive an invoice for something, it’s not considered an expense until you’ve actually paid for it.
The cash accounting method can very quickly give you a very clear picture of where your company stands financially at any point in time as you know exactly how much money you’ve got.
On the flip side, what the cash accounting method doesn’t do is tell you just how much money you are owed or even how much money you may owe. This can work to your disadvantage as it may give a false picture of the profitability of your business. It is for this reason that this method of calculating revenue is best suited for sole proprietors or smaller businesses that are paid right away, with little or no inventory, such as a hairdresser.
Accrual Accounting Method
While the accrual accounting method is more complicated than cash accounting, it has the ability to give you a more accurate picture of your company’s financial position since you can take into consideration how much money is owed to you and how much you owe.
Under the accrual basis, revenue is recorded when a sale has been made. This can be done for goods sold on credit or services already performed. To calculate your earnings successfully using the accrual method, you may want to familiarize yourself with the revenue recognition principle, to help you determine at which point revenue is to be recorded and recognized on your income statement with the least amount of risk.
Experts recommend that you recognize revenue when you have transferred the majority of the benefits and risks of owning a product to the buyer, or when you’ve successfully delivered the service. What this means is that if the goods that you’re selling are being delivered to the buyer or if you’ve completed the project that you’re meant to, you can record the value of the goods or services as revenue in your income statement (usually when an invoice is created), even if you haven’t received payment.
Using the same principle, expenses are also recorded even if payment hasn’t been made, when materials have been ordered or when an invoice has been received.
If you use the accrual accounting method, you’ll also need to keep a close eye on your cash flow statement, as this will give you an indication as to how well you’re collecting any money owed — a value that appears on the balance sheet as accounts receivable. You’ll then make adjustments to the cash balance and accounts receivable when payment is actually received.
Consider using the accrual accounting method if:
- You operate a business with an inventory
- You sell on credit
- You have lots of contracts
- You don’t get paid immediately for services rendered
The Importance of Revenue on Your Income Statement
As a small business owner, understanding the answer to “what is revenue” is crucial as it plays a vital role in your company — it’s what pays the bills (and your employees). To continue running a business without revenue will often mean borrowing, either from your existing cash balance or from a bank.
But remember that it’s also important to look at your revenue in the context of your income statement as a whole. While you can adopt certain strategies to increase your revenue, such as advertising, raising your prices, or expanding, a high revenue with an even higher expense will still result in a net loss for your company.