2. Revenue and Revenue Recognition

 
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Overview

Revenue is at the beginning of every Income Statement. In this lesson, I'll show you how to calculate revenue growth and understand the concept of revenue recognition

Lesson Notes

Revenue and Revenue Recognition

- Revenue is not the same as cash or sales
- Analysts always need to examine the difference between cash and revenue
- To recognise revenue, a number of criteria must be met

Revenue criteria

- There is evidence of an arrangement between buyer and seller
- The product has been delivered or service has been rendered
- The price is determined or determinable
- The seller is reasonably sure of collecting the money

Transcript

The Income Statement typically represents the financial results of a business over a three-month, six-month or annual time period. It communicates how much revenue the company has generated in the period, including tax and the associated expenses incurred, generating this revenue. Revenue minus expenses leaves you with profit or a loss. As a result, the Income Statement is also known as the P and L, standing for profit and loss. Looking at the MarkerCo Income Statement, at the top we have the revenue figures for 2012 to 2015. The Income Statement is roughly divided into four parts. First, at the top, revenue and cost of goods sold that provide us with gross profit. Next, our operating expenses, such as sales, general and administrative, depreciation and amortization. Next, is the interest and taxes, which finally lead to net profit. In this lesson, I'm going to focus on the first section. MarkerCo's Income Statement divides revenue into two types: hardware and consulting. Whenever an analyst sees figures like this, they immediately calculate the annual growth rate, which is a big indicator of performance. So, let's go ahead and do this for both revenue streams.

So, I'll create a new row with Alt + I, R and I'll call this "consulting growth rate".

(keyboard clicks) For 2013, I'll take consulting revenue, subtract 2012 revenue and divide by 2012 revenue and I'll copy across with Ctrl + R and format as a percentage with Alt + H, P and as you can see, the consulting revenue is growing very quickly year on year. Let's now repeat this for hardware revenue. So, again, I'll create a new row.

I'll call it "hardware growth rate" (keyboard clicks) and perform the same formula, taking 2013 revenue, subtracting 2012 revenue and dividing by 2012 revenue.

I'll copy across with Ctrl + R and Alt + H, P for percentage growth rate and as you can see, the consulting business is growing much faster than the hardware business, although the hardware business is still providing more dollar revenue. One thing to bear in mind when analyzing revenue is that revenue does not always equal to sales and revenue does not always equal to cash received. I'll explain this concept in more detail with a simple example. Let's say we sell a piece of hardware for $800 on the 14th of December 2015.

The invoice goes the customer and they pay us a couple of weeks later on the 10th of January 2016.

Our 2015 sales figure will include $800, but our 2015 cash position will not.

Now, let's take a similar example for the consulting division. On the first of January 2015, let's say we sign a three-year contract to provide consulting services to a client for a total cost of $21,000. The client agrees to pay, upfront, the full amount. Our cash position for 2015 will include the $21,000.

Our sales position will include the $21,000, but our 2015 revenue can only include the first of the three years' work, which will be a fraction of the $21,000, let's say a third, at $7,000.

As you can imagine, different businesses have different revenue, cash and sales characteristics and it's important, as an analyst, that you understand the revenue recognition policy for companies that you're reviewing. This concept called, "revenue recognition", can get quite complex from an accounting perspective. However, for our needs, as beginners, we just need to remember the following four criteria to determine when revenue has been earned in a period. First, there is evidence of an arrangement between the buyer and seller. Second, the product has been delivered or the service has been rendered. Third, the price is determined or determinable and fourth, the seller is reasonably sure of collecting the money. In the next lesson, we'll wrap up or look at this section of the Income Statement by exploring the cost of sales or the cost of goods sold and gross profit.