Earnings are one of the most closely monitored metrics of any business because it reveals how much money the business truly made once all costs have been subtracted from its income. Companies can then monitor this figure and compare it over time to ensure its performance is on track or if any issues may be developing. Investors will also rely on earnings as a key indicator in determining a stock’s market value.
How Are Earnings Calculated?
Earnings are found by taking a company’s revenue and subtracting each of the costs of doing business. This can be described with the following equation:
Earnings = Revenue - COGS - Operating Expenses - Taxes
- Revenue - Income or sales for the company
- COGS (Cost of Goods Sold) - The direct costs involved with the sale of its products. This generally includes the price of the materials, labor, and any overhead associated with its production.
- Operating Expenses - Indirect costs needed for the operation of the business. This category may include such expenses as insurance, legal fees, management salaries, administrative payroll, etc.
- Taxes - Payments levied by federal and local municipalities on a company’s income
Earnings Calculation Example
Let’s say that a company has $1 million in sales for the quarter. At the same time, they spent $500,000 on parts and labor to produce their goods plus another $200,000 on indirect costs. Additionally, they also had to pay $175,000 in taxes on their gross profit.
Putting this all together, we can say that the company’s earnings for the quarter are:
$1,000,000 - $500,000 - $200,000 - $175,000 = $125,000
In other words, after we subtracted all outgoing cash from the company’s revenue (including taxes), we can see that it truly made $125,000 for its owners (i.e., the shareholders).
Earnings Metric Variations
While calculating net profit is the most straightforward way to find a company’s earnings, it's not the only method that financial analysts use. The following are a handful of other useful earnings metric variations:
- EBT (earnings before taxes) - Also referred to as pre-tax income, this calculation for earnings strips away taxes. This can be helpful for making comparisons between companies that may be subject to different tax rates. Alternatively, it can also be useful for making comparisons over various time periods when tax rates may have changed.
- EBIT (earnings before interest and taxes) - This variation strips away both taxes and interest. It builds upon the advantages of using EBT but also removes the costs of the capital structure revealing more about the company’s core operations.
- EBITDA (earnings before interest, taxes, depreciation, and amortization) - This calculation eliminates all of the effects of accounting decisions and financing. Reporting earnings in this way gives analysts a better perspective as to how the company is truly performing and allows comparisons with other businesses to be better normalized.
What's the Difference Between Revenue vs Earnings?
From time to time, business professionals will mistakenly say revenue when they are talking about earnings and vice versa. However, these two terms have completely different meanings.
Revenue is the amount of sales a company has made based on the price of its products and services. It appears as the top line in an income statement because it is the main input of the business (i.e., the inflow of cash).
On the other hand, earnings are the amount of money that a company has left after its paid everything it owes (expenses, taxes, etc.). It appears as the bottom line in an income statement because it's the final value after all costs have been subtracted from the revenue.
Why Are Earnings Important?
A company’s earnings can be used in several ways.
The main reason for determining the earnings of a business is to see whether it is profitable or not. Managers need this information to make sure that the company can operate like normal, and investors need to know that they will make their money back.
The company’s latest earnings report can have an effect on its stock price. Analysts will often make predictions for major companies about their upcoming earnings figures. Typically,
- If the company underperforms its earnings forecast, then the stock price will fall.
- If the company over-delivers its earnings forecast, then the stock price will rise.
Hence, since companies don’t want to see their equity shares go down in value, they take steps to ensure that their earnings figure is robust.
Company earnings are also used for stock market metrics. Perhaps the most well know is the P/E ratio or price-to-earnings ratio. This metric compares a company’s current stock price and divides it by its earnings per share (EPS) - the amount of profitability on a per-share basis. The result is a ratio that is generally interpreted as:
- High P/E - Overvalued against other companies within the same industry
- Low P/E - Undervalued against other companies within the same industry
The P/E ratio is one of the most widely quoted metrics that’s displayed when viewing the fundamentals of a company. However, like all stock metrics, it should never be used in isolation.
The more earnings that a company has, the better its prospects for the future. A company with excess cash can use it to reward its shareholders with dividends. Alternatively, they can also use the funds to grow their operations, develop other product lines, or acquire other businesses.
The Bottom Line
A company's earnings are the number of net profits or after-tax income produced within a given quarter or fiscal year. It can be calculated by taking its gross revenue and subtracting away all costs. This is why it appears as the bottom line on an income statement.
Business managers and owners will closely monitor earnings because it reveals how much the company is actually making. Earnings reports will also have an impact on the share price and other stock analysis metrics. Overall, a company needs to measure its earnings to ensure that its making money for its owners and has future sustainability.