Understanding how fast a company is growing is a critical component of any stock analysis. Selling a product or service is the most fundamental factor in the success of any business, and revenue growth rates are a direct way to assess how successfully a company is doing exactly that.
How to calculate total revenue growth
To calculate total revenue growth, subtract the most current period's revenue by the revenue number from the same period in the prior year. This could be the current year's annual revenue and last year's annual revenue, this quarter and the prior quarter, or this quarter and the previous year's comparable quarter. All that matters is that you choose two time periods that are equal in length. These numbers can all be found at the top of the company's income statement, reported quarterly and annually.
Next, divide that difference by the revenue number from the prior period. Multiply that by 100, and you'll have the percentage growth rate of total revenue between the two periods.
For example, a company reports $1.2 billion in total revenue last year and $1.8 billion for the most recent year. This year's $1.8 billion minus last year's $1.2 billion is $600 million in actual revenue growth. Next, we divide $600 million into last year's $1.2 billion revenue number. That's 0.5, which times 100 gives us 50%. Therefore, this hypothetical company had total revenue growth of 50% from last year to this year.
An important consideration in how revenue accounting works that can make a big difference in growth rates
Thanks to the rules of accrual-based accounting, just because a company shows an increase in revenue doesn't necessarily mean the company has received any cash payments for goods or services. It sounds crazy, but even revenue can be manipulated by complex accounting.
The accounting rules dictate how much revenue to show and when to show it with a set of rules called revenue recognition. Most simply, a company should recognize revenue -- meaning put it on its income statement -- when it has been earned. In many cases that's easy -- when you buy an apple at the grocery store, the store earned that revenue the instant that you pay for the apple. It becomes more complex though when you consider many business to business transactions.
For example, a contractor may buy lumber from a building company today but may not pay for the lumber for a few weeks. In this case, the building company would recognize the sale as revenue the instant the contractor takes the lumber, even though no cash has changed hands. The building company won't receive the payment until the contractor pays his invoice at the end of the month, potentially weeks or months after the revenue was recognized.
More complicated still, consider a software company that signs a large contract to sell its software along with ongoing support and consulting to an industrial firm.
The first complication is that the initial delivery of the software will be recognized in a different way than the revenue from the ongoing support and consulting. The portion of the contract for the software will be recognized when the deal is closed, but don't forget that, as we already saw, this doesn't necessarily mean any cash has changed hands, either. The support and consulting portion of the contract won't be recognized immediately. Instead, that revenue won't appear on the income statement until those services are provided, probably on an incremental basis throughout the duration of the contract.
Then there is the issue of when the contract takes effect. If the two companies come to a verbal agreement on Sept. 15, in the third quarter, but the final contracts aren't signed until Oct. 1, the portion of the contract pertaining to the sale of the contract will be recognized in the fourth quarter, even though the deal was agreed to verbally in Q3. Had the contracts been signed on Sept. 30, then those numbers would show up in Q3 results. That could drive a potentially huge swing in each of these quarters' numbers.
Complicated enough for you? And that's a relatively simple example of a single contract.
Don't worry: Most of the time, investors need not get lost in these weeds
For large-cap companies with billions and billions of dollars in revenues, the sheer size of the company and massive diversity of customers will prevent these issues from making a material impact on total revenue from quarter to quarter. In those cases, you shouldn't worry too much about the validity of a company's top-line revenue.
However, for smaller companies with more concentrated customer bases and lower overall revenue, it's possible that these accounting rules, and others like them, can significantly affect revenue. Management can control when contracts are signed, how contracts are structured, and a myriad of other factors to manipulate when and how much revenue is recognized in any given quarter.
That's why it's so important for investors not just to understand total revenue growth rates, but also to consider company's size, its business model, its accounting method, and any possible impacts these could have on revenue recognition.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.