fundamental analysis: the importance of revenue vs. net income

This seems straightforward, hopefully I understood your question correctly.

If net income increased 72% YoY, then investors benefit from greater return on equity (equity hasn't changed).

It depends on how they cut costs so dramatically. If they fired half of their workforce, for example, but were able to fulfill most of their existing sales, then their future could be severely limited. Or if their expenses last year were unusually high due to some impairment or other non-recurring event.

In general, yes, more income is generally a good thing, but you have to look deeper at the reasons for that growth. Such a disparity in revenue growth and income growth is definitely a red flag worth investigating to decide if the reason will be good news for the future (which is what stock prices should be based on).

In theory, you could say Net Income is the "ultimate" test of a company's financials. No matter what anything else looks like, net income is the only thing that actually creates profits distributable as dividends. However, context is crucial in financial analysis, and from a long-term standpoint, net income this year is not the only thing that matters - other indications of performance can also dictate both this year's success as well as future profitability.

If revenue is shrinking as net income rises, there could be many reasons. For example:

• Perhaps the company dropped a line of business that was a 'loss leader' item that actually cost the company profits even though it earned 'top-line' revenue [for example - maybe a supermarket bakes bread at a cost of $1.5 a loaf, but sells it at $0.50 a loaf to get buyers in the store, who then also buy items with a higher profit margin. After dropping the bakery section, maybe the store realizes that people would still come to buy the high-margin items anyway, so they stopped losing money on bread but kept earning high-traffic profits]. In a case like this, the higher profits might continue, so this could be a good sign that management is making effective changes to their business model.

• Perhaps the company shut down its entire research department, so less corporate costs means higher profits this year, but there will never be a new product again. If the company is in a dying industry [they make VHS players and will never make anything different now], this could be a very bad sign.

• Maybe things are slowly declining in general, but the company sold some unused land for a single-year gain. This won't be repeated, but if the land wasn't used anyway, this isn't necessarily a bad decision to have made.

In your example, I would say the disparity between NI change and Rev change are almost ludicrous. So much so that management would no doubt release commentary explaining the shift in business fundamentals in the MD&A report attached to the annual financial statements. A change so large would, in my opinion, either be an indication of something really good [if it is achievable year-over-year] or something really bad [this might be the last good year before quick-buck thinking costs the company everything].

In financial analysis, context is everything - stopping at review of just a couple of line items could make you miss something critical.

EARNINGS is a measure of how good a company is at capitalizing off of their assets and optimizing their costs, and can be used to measure ROA and ROE, whereas REVENUE is a good indicator of how quickly and effectively management is at directing a company's growth and penetration into the market. like you said, they're both important. but this comes with caveats.

EARNINGS figures can be legally manipulated in several ways, and should be taken with a grain of salt, whereas top-line REVENUE is slightly more limited in the number of pernicious but legal ways to be fudged.

on the other hand, there's one form of revenue manipulation that's legal and probably the most common trick utilized by management.

how are earnings manipulated? there are several ways:

1. STOCK BUYBACKS: EPS is calculated as EPS = (NI - P/O)/CSO. If a company initiates share buybacks, CSO decreases and resultantly EPS increases, projecting a false narrative that the company is more profitable than it actually is. not all stock buybacks are immoral, but they can be used in insidious ways.
2. ACCRUAL OF EXPENSES: a corporation can report an expense, such as hiring contract work or consultants, when the expense is paid instead of when the service was rendered. it's a way for companies to push back the expense on their official SEC forms to a later quarter for advantageous reasons
3. TIMING OPERATING ACTIVITIES: this relates to prudently selecting when to time costly operational needs to a quarter that benefits the corporation in terms of SEC reporting while also minimizing any time-to-market problems or inventory shortages.
4. TRANSLATING BUSINESS EXPENSES: it's possible to shift operating costs away from the income statement and to the balance sheet by making them look like a current or LT "liability" instead of what they really are - a periodic, regular expense.
5. CLASSIFICATION OF ASSET SALES: assets (such as plants and machinery) that are sold but classified as "other income/expense" will inflate earnings
6. AMMORTIZATION OF INTANGIBLES COSTS: the ability to amortize the R&D costs of developing an intangible, such as in-house application software, across its life cycle, up to 3-5 years, instead of representing it as a one-time expense on only 1 quarter's financial statements
7. AMMORTIZING COSTS TOO SLOWLY: operating costs can be severely understated if a company uses an estimated average that's too small.
8. ONE-TIME RESTRUCTURING PAYMENTS: sometimes a company wants to focus on their most competitive areas of expertise by reallocating its efforts from unlucrative segments. if a company is restructuring its business, eliminating business segments, discontinuing a product or service, or relocating its activities to a new region, the costs associated with such a process are tabulated into the income statement, but often are ignored by analysts and institutional investors, since it's not a recurring charge. as a result, the stock might not lose value, but these events can financially strain the company, and don't guarantee future success.
9. FUDGING ACCRUALS AND GOODWILL FROM MERGERS: mergers and acquisitions also represent a one-time expense, and there are a plethora of methods a company can misrepresent the goodwill value added from an acquisition, or attribute more/less expenses than is necessary to complete the merger and any restructuring involved.
10. MATERIALITY FUDGING: company can fudge the numbers by a small amount, within the acceptable margin of error set forth by the SEC, either knowingly or unknowingly. although mostly immaterial on each individual income statement, in the broader term, this will make their retained earnings figures on the balance sheet materially wrong

However, there are clever things they do with the revenue line item, as well, like:

• counting units that are still in distributors' inventories (and not yet sold) as "revenue",
• → ◆ a̲g̲g̲r̲e̲s̲s̲i̲v̲e̲l̲y̲ ̲b̲o̲o̲s̲t̲i̲n̲g̲ ̲s̲a̲l̲e̲s̲ ̲b̲y̲ ̲p̲r̲o̲v̲i̲d̲i̲n̲g̲ ̲o̲v̲e̲r̲t̲i̲m̲e̲ ̲a̲n̲d̲ ̲o̲t̲h̲e̲r̲ ̲i̲n̲c̲e̲n̲t̲i̲v̲e̲s̲ ̲t̲o̲ ̲i̲t̲s̲ ̲l̲a̲b̲o̲r̲ ̲f̲o̲r̲c̲e̲ ̲d̲u̲r̲i̲n̲g̲ ̲t̲h̲a̲t̲ ̲s̲p̲e̲c̲i̲f̲i̲c̲ ̲q̲u̲a̲r̲t̲e̲r̲ ◆ ←, and even
• reporting future revenue from multi-year or multi-quarter contracts.

While there aren't quite as many unique types of revenue games as there are for operating costs, t̲h̲e̲ ̲m̲o̲s̲t̲ ̲c̲o̲m̲m̲o̲n̲ ̲t̲a̲r̲g̲e̲t̲ ̲o̲f̲ ̲m̲a̲n̲i̲p̲u̲l̲a̲t̲i̲o̲n̲ ̲(̲o̲n̲ ̲a̲n̲y̲ ̲f̲i̲n̲a̲n̲c̲i̲a̲l̲ ̲f̲o̲r̲m̲)̲ ̲f̲r̲o̲m̲ ̲t̲h̲e̲ ̲m̲a̲n̲a̲g̲e̲m̲e̲n̲t̲ ̲t̲e̲a̲m̲ ̲i̲s̲ ̲f̲o̲r̲c̲e̲f̲u̲l̲l̲y̲ ̲t̲i̲m̲i̲n̲g̲ ̲t̲h̲e̲ ̲r̲e̲c̲o̲g̲n̲i̲t̲i̲o̲n̲ ̲o̲f̲ ̲r̲e̲v̲e̲n̲u̲e̲,̲ ̲a̲s̲ ̲l̲i̲s̲t̲e̲d̲ ̲a̲b̲o̲v̲e̲.

As investors, we should be aware of these things in order to guard ourselves from manipulation.

With a final note, you can refer to a company's so-called Beneish m-score, a weighted score of financial metrics and key ratios, in order to determine if a company is a likely manipulator of their financial documents. It's not a perfect test, but it can certainly be a double check of extra scrutiny.

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