Does high revenue mean more profit? Not necessarily. A company could experience a spike in revenue, yet see a decline in profits. Let’s get it right once and for once: a company might witness a rising revenue, but declining profits.
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How increasing revenue and declining profits happen
We already spelt out distinctions between revenue and profits. However, you may have heard about instances whereby a company experienced higher revenue, but decreasing profits, of course, this does happen for some possible reasons. Here are reasons why a company can have a rising revenue, declining profits:
Higher operating costs:
If a company is bringing in more revenue while the costs of labour costs, overhead costs, and other operational expenses rise faster than the revenue, it will lead to a decline in profits.
Economic factors:
When there are increased competition (like new alternative products in the market), inflation, and changes in market demand, the company may experience higher costs or lower sales volumes, thereby impacting profits despite higher revenue.
Investment in growth:
A company might be investing heavily in growth initiatives such as research and development, marketing, and expanding into new markets, these might lead to higher revenue, and they might affect the company’s profits in the short term.
Examples of increasing revenue, declining profits
Example 1: Why Tesla recorded high revenue and declining profits in 2015
In the year 2015, Tesla Motors Inc. experienced a higher revenue, but a wider net loss (negative profit), reporting $4.05 billion in revenue (a considerable increase from the $3.20 billion in 2014), but a record loss of $889 million in 2015. The automotive company recorded a net loss of $294 million in 2014.
Tesla’s increase in revenue or top-line growth didn’t stop it from experiencing a decline in its bottom line (profits).
It is important to point out that in 2015, Tesla saw 50, 658 total sales of its Model S and Model X, compared to 2014 when it saw 31, 655 total sales in Model S.
So, you might wonder how did Tesla Motors sell more yet lost more money, meaning increasing sales or revenue is not automatic to making profits. Here is what happened to Tesla:
R&D Costs:
The car manufacturing firm invested heavily in Research and Development (R&D) in 2015 to the tune of $718 million compared to $465 million in 2014.
While expansion was essential for Tesla’s growth for it to stay ahead in the electric vehicle promising market, the R&D costs added a substantial cost.
Production & selling costs:
Production and Selling Costs: The company’s production and selling costs also rose in 2015 compared to 2014, including labor, factory overheads, raw materials and many more.
Administrative expenses:
Selling General and Administrative (SG&A) expenses of Tesla Motors also rose in 2015 which include expenses related to personnel, facilities, sales, and marketing etc.
Example 2: Why Uber recorded high revenue and declining profits in 2019
Similarly, another American technology company known for its ride-hailing services Uber Technologies Inc., reported full-year revenue of $14.15 billion in 2019, compared to 2018 when the company reported $11.3 billion.
You might expect that more revenue means more profits, however, Uber toed the negative path by reporting a staggering net loss of $8.5 billion in 2019, compared to a net loss of $1.8 billion in 2018.
The ride-hailing company recorded losses due to rising R&D costs, stock-based compensation to employees, and sales and marketing expenses. These factors combined led to a situation where Uber’s total expenses rose faster than its revenues, resulting in a larger net loss despite the higher revenue.
Effect of declining profits and high revenue
A company could face some potential management issues if it consistently experiences high revenue but decreases profits over a certain period. They include:
Difficulty in raising capital:
For Tesla, Elon Musk was able to raise capital because of its diversified investments. However, it may not be easy for some companies to raise capital for business expansion when they witness declining profits because lenders and investors could view it as a high-risk investment.
Limited growth opportunities:
When a business continues to face consistent reductions in profits, it might hinder or restrict its ability to invest in new opportunities which may stunt its growth potential.
Low morale from staff:
More profits are seen as one of the indicators of growth, but when net income continues to drop year in, and year out, it could lead to employee morale dropping, which could result in higher employee turnover.
Cash flow problems:
Profits are the largest contributor to the cash flow of a business, so, when profits continue to decline, it could lead to cash crunch. Cash crunch will make it challenging for the company to meet its financial obligations.
Investor concerns:
The financial health of a business may come under serious scrutiny by investors when a company’s ability to generate a return on their investment. This could affect the company’s share price.
Bankruptcy risk:
The worst case of decreasing profits or inability to turn things around could be bankruptcy.
How a company can avoid a decline in profits
While decreasing profits, and increasing revenue could have a negative impact on a business’s continued existence, there are a few strategies a business can deploy to mitigate further loss:
Focus on customer retention:
Retaining existing customers is often more cost-effective than acquiring new ones. So, companies can look at ways to improve customer loyalty and increase repeat business.
Strategic investments:
A company’s investment must be worth every penny it spends or invests. While investing in growth is essential, it’s equally important to measure the return on these investments. Companies need to ensure that their investments – whether in marketing, R&D, or otherwise – are resulting in sufficient revenue growth to justify the expense.
Diversification:
Exploring new markets is great. Companies can consider diversifying their products or services to tap into new markets or customer segments, which can lead to higher sales volumes and thus higher profits.
Control operating costs:
A company must keep a close eye on operating expenses. Some of the ways to achieve this include renegotiating supplier contracts, improving operational efficiency, or even reducing energy usage.
Pricing strategy:
Sometimes, a decline in profits could be due to underpricing products or services. A well-planned pricing strategy that takes into account the costs, market demand, and competitive landscape can help improve profitability.
Effective inventory management:
For companies dealing with physical products, effective inventory management can help reduce storage costs and prevent losses from unsold goods.
Impact of government’s economic policy on revenue & profits
A company may try its best to increase its profits to align with its revenue, but some economic policies of a country can also affect the company’s revenue in several ways, such as:
Monetary policy changes:
Central banks’ policies that lead to higher interest rates can increase borrowing costs for companies, reducing their profits.
Foreign exchange policy:
If a country floats its currency without adequate measures to mitigate its impact on multinationals that repatriate their profits in foreign currency, it could affect their profits.
For instance, some companies in recent times recorded losses after Nigeria floats it currency where Nestle Nigeria reported N123.7 Billion in forex losses; MTN’s earnings also decline by 64% due to N131.4 Billion in forex losses.
Changes in tax policy:
If a country increases its corporate tax rate, companies will have to pay more in taxes, which will reduce their after-tax profits, even if their revenue remains high.
Changes in trade policy:
If a country implements more stringent trade policies, such as higher tariffs or quotas on imported goods, companies may face increased costs for imported raw materials or components, which could lead to declining profits.
Regulatory changes:
New regulations in areas such as environmental standards or industry-specific regulations can lead to increased compliance costs, impacting profits.
Changes in labor laws:
If a country introduces new labor laws that increase the minimum wage or require additional employee benefits, companies may face higher labor costs, reducing their profits.
Conclusion:
Reasons a company’s revenue increases while its profits are decreasing are R&D costs, production & selling costs, selling general and administrative (SG&A) expenses, sales and marketing expenses, and stock-based compensation.
The two examples cited in this article mean that sales or revenue is not enough. Companies also need to carefully manage their expenses to ensure that they are not outpacing revenue growth, or else they might find themselves in a situation where increased sales are accompanied by declining profits.
