Finance for Entrepreneurs: Understanding Revenue

Revenue is a very funny line in the profit and loss statement. If you remember from our earlier lesson, the profit and loss statement is also known as the income statement. In the income statement, right at the top one will find the revenue mentioned. What comprises revenue? How is it measured? These will be discussed in this lesson.

Revenue is measurement of the sales that the business has achieved. It is fairly clear metric to measure and compare since there is very little difference on the understanding between enterprises. While some entrepreneurs call something revenue only when they collect cash or receive cash from the client, for accounting purposes it is considered otherwise. Every time a business raises an invoice the value of the invoice gets added to the top line. Revenue is also popularly called Top Line.

Since there is common understanding (thanks for Generally Accepted Accounting Practices or GAAP) regarding how revenue should be captured it is easy to use it for comparison and benchmarking. While profits can be easily modified and played around with, revenue in general is not. I agree that there are exceptions and in this case probably exceptions are not really the examples to follow! Fabricating financial statements is something that makes reading and evaluating them a difficulty. But since we are learning finance more for internal analysis, we will ignore decorating financial statements for a while. In later lessons we will discuss how to find these smart modifications and how they lead to ethical dilemmas.

Revenue also is a way to capture revenue streams of a business. Segregating the revenue line into sub heads will tell us where the money is actually coming from. If the start-up has revenue from multiple products or services, they should be individually captured so as to understand the revenue mix. It will also tell us which products are really taking off and which are pulling the start-up down? It is important to split the non business operations revenue from the primary business operations revenue. This is important because as an emerging business the source of your inflow is more important than the inflow itself. If your business operation is showing promise, then investors and other stakeholders will show more interest on your enterprise. On the other hand, if revenue quality from primary business operations is not showing great improvements then it may indicate lack of growth potential in the enterprise.

What could be revenue from non primary business operations? I am sure as an entrepreneur you are surprised about this. I am struggling to make money from selling my products and services, and where is the time to make money from other sources? But you will be surprised that after a few months / years into enterprise creation, the pressure to show revenues makes entrepreneurs do some standard mistakes. Here are two such situations:

a)      Doing adjacent or non primary business sales: If you are a product company, invariably one ends up making money out of services at the start. Slowly and steadily the services income becomes stable and the enticement of revenue and profits delays product creation. This also reduces focus of the entrepreneurial journey. Example: Electronics based product start-up ended up building circuit boards and custom requirements to make money in the interim period, but since their core engineering team ended up splitting the time between products and services, the product development suffered. This led to poor marketing efforts as well for products. But during the entire period the sales and thereby the revenue kept increasing. Any evaluation on a broad basis showed the start-up improving top line every quarter, but one realizes that they are no more a product start-up that they intended to be. When they visit investors and showcase their enterprise for large equity investments, they don’t get interest and they continue to wonder why?

b)      Parking extra money in interest generating financial instruments: If a start-up makes money from interest, it is a smart thing. It is smart thinking from the entrepreneur. She/he quickly realizes the importance of not keeping money idle in the current accounts (which don’t give interest as against savings accounts which give a nominal interest). Hence they act like money managers constantly moving money in and out of the current account. This takes time and effort. At times this interest income can be as large as 10% – 15% of a start-up’s profit. This makes the activity more interesting. But percentage based calculations also makes one forget two things: one, the business of the entrepreneur is making the product/service and not money management; and two, if you don’t find investing the money into your own business more exciting than putting it in revenue generating financial instruments, it speaks a lot to future investors. I am not saying utilizing money to make money through short term financial investments is bad, but it distracts.

Hence breaking up the revenue line in the business is a clear indicator to the entrepreneur of how the enterprise is performing. Capturing the revenue as soon as invoice is generated also keeps the enterprise on their toes to make collections. Entrepreneurs must learn to split revenues into those from primary operations (reason why you started the firm) and from all others. Every time the non operations revenue is going higher than the primary intended revenue from operations, one needs to check why? It could also mean that it is time to change focus and trigger plan B – who knows?

The objective of the lesson was to expose to entrepreneurs to what revenue means on an income statement and what comprises it. The lesson also highlighted the importance of maintaining a detailed revenue block, review the revenue based on operations and others, and constantly ask oneself if this is how you want to enterprise to be and where this would lead a year from now. Two common smart but erring (may be) actions of entrepreneurs have also been highlighted as well. While no action is outright wrong, it is important to know why we engage in them!

Think!

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