What Are Earnings and How Are They Calculated?

Corporate earnings represent the profit a company generates over a specific accounting period, like a quarter or a year. This figure indicates a company’s financial performance and operational efficiency. Understanding earnings provides a picture of a company’s overall health, and the calculation is governed by established accounting principles to ensure consistency.

The Calculation of Corporate Earnings

The calculation of a company’s earnings begins on its income statement, a financial report that summarizes revenues and expenses. The starting point is Revenue, or sales, representing the total money generated from primary business activities. For a retail company, this would be cash from selling merchandise; for a software firm, it would be subscription fees.

From revenue, the first deduction is the Cost of Goods Sold (COGS). This includes direct costs attributable to production, such as raw materials and direct labor. Subtracting COGS from revenue yields Gross Profit, which shows the profit a company makes from selling its products before other business expenses are considered.

Next, Operating Expenses are subtracted from the gross profit. These are costs incurred to run the core business that are not directly tied to production, including marketing, salaries for non-production staff, and rent. The result of this subtraction is Operating Earnings, or operating income. This metric reflects the profitability of a company’s central business operations.

To arrive at the final earnings figure, non-operating items are accounted for. This involves subtracting interest expenses on debt and adding any non-operating income, resulting in earnings before tax. After subtracting corporate income taxes, the final number is Net Income. In the United States, the federal corporate income tax is levied at a 21% rate.

For example, a company with $1 million in revenue, $400,000 in COGS, and $200,000 in operating expenses has an operating income of $400,000. After subtracting $50,000 for interest and $73,500 in taxes, its net income would be $276,500.

Common Earnings Metrics for Investors

Investors use net income to calculate several metrics, with one of the most cited being Earnings Per Share (EPS). This metric allocates a portion of a company’s profit to each share of common stock. Under U.S. Generally Accepted Accounting Principles (GAAP), companies report both basic and diluted EPS. Basic EPS is calculated by dividing net income available to common shareholders by the weighted-average number of common shares outstanding.

Diluted EPS presents a more conservative view by considering the impact of all potential shares from instruments like stock options or convertible bonds. It shows what EPS would be if all dilutive securities were exercised, increasing the total shares and lowering the EPS figure. Investors often focus on diluted EPS as it provides a “worst-case” scenario for their claim on earnings.

Another common metric is EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. EBITDA is a non-GAAP measure, meaning it is not standardized by accounting rules, but it is used to assess a company’s core operational profitability. By adding back non-cash expenses, interest, and taxes, EBITDA allows for a clearer comparison of operating performance between companies. However, it can overstate cash flow because it ignores changes in working capital and the need to replace old assets.

The earnings figure is also a component of the Price-to-Earnings (P/E) Ratio, a valuation tool. This ratio is calculated by dividing a company’s market value per share by its earnings per share (EPS). A high P/E ratio might suggest that investors expect higher future earnings growth, while a low P/E ratio could indicate that a company is undervalued.

The Role of Retained Earnings

After a company determines its net income, it can either distribute the earnings to shareholders through dividends or reinvest the money back into the business. The portion of the profit not distributed as dividends becomes Retained Earnings, representing the cumulative net earnings the company has kept.

Retained earnings are not a cash reserve but an entry in the shareholders’ equity section of the company’s balance sheet. This accumulated capital is used to fund various growth initiatives, such as:

• Research and development of new products
• Purchasing new machinery or facilities to expand capacity
• Paying down existing debt
• Executing strategic acquisitions

The decision to retain earnings signals management’s confidence in its ability to generate a better return by reinvesting the profits.

The flow of these funds is detailed in the Statement of Retained Earnings. This financial statement provides a reconciliation of the retained earnings account from the beginning to the end of an accounting period. The calculation is: Beginning Retained Earnings + Net Income (or – Net Loss) – Dividends Paid = Ending Retained Earnings. This statement serves as a bridge, linking the net income from the income statement to the balance sheet.