The facts behind negative net income are clear. Negative net income is when a company’s expenses are larger than their revenues. Simple as that.
What’s maybe less clear are the implications to a company with negative net income.
- Is negative net income something to be ignored? Sometimes.
- Is negative net income a bad development for a business? Sometimes.
- Can a company have positive cash flow but negative earnings? Sometimes.
It’s some of these questions and more I’ll try to answer for everyone today. But first let’s go back to the basics of Net Income and its place in a company’s income statement.
Basics of an Income Statement and Net Income
The most simple structure of an income statement can be defined as:
- (minus Cost of Goods)
- Gross Profit
- (minus Operating Expenses)
- Operating Income
- (minus Taxes and Interest)
- Net Income
It’s from Net Income, or “Earnings”, that you get Earnings Per Share, which is probably the most widely followed metric on Wall Street most of the time (unless talking about a growth company).
In the most general of terms, negative net income tends to happen in three situations:
- A company is in a growth stage and heavily reinvesting
- A company has money losing operations
- A company has to write-down a loss on its books
I think it’s important to understand that most investors tend to overlook negative net income as any sort of signal at all, especially because there can always be underlying reasons behind them in each of the three situations above.
- A growth company with negative earnings is actually very common especially with young companies
- Years of money losing can easily be justified away as temporary.
- A loss on the books can easily be excused as “spilled milk” and unimportant because it’s “non-cash”.
But before we dive deeper into those common explanations for negative net income, I want to tell you a story about my experience with negative earnings.
Bankruptcies and Negative Net Income
I’ve always been an extremely risk averse investor. I think watching my dad lose two stable jobs in a short time from a sluggish economy made me really skeptical of economy.
This had to have spilled over into my ideas about the stock market, which I originally perceived as very risky and unpredictable.
Eventually I educated myself and learned the history and tendencies of the stock market, which has helped me to feel confident in investing in it.
But for whatever reason—I was drawn to what Charlie Munger refers to as,
“All I want to know is where I’m going to die, so I’ll never go there.”
In the case of buying stocks, that place where investors die in its most simplest form is companies that go bankrupt. With this approach I studied over 30 of the biggest bankruptcies of the 21st Century.
The results were fascinating, but here was the most enlightening:
Over half of the bankrupted companies had negative net income.
I looked at all sorts of financial metrics when it came to these companies and tried to find a signal or indicator to why they would go bankrupt. There was some that logically had more debt, or more expenses, or of course revenue struggles…
But the biggest, BIGGEST, common factor in companies that went bankrupt was negative net income.
With that backdrop in mind, I think we need to remember as we dive deeper into the reasons of negative net income that it’s probably a great idea to respect negative net income for the potential bad indicator that it is.
In many of the bankruptcy cases, it took just one year of negative earnings to wipe them out!
So of course you’ll always want to dig deeper when you see a company with negative net income, but in general, it’s probably a huge red flag. So proceed with caution.
Negative Net Income from Operating Losses
Let’s review the income statement again because it’s important in understanding how Net Income is ultimately derived.
- (minus Cost of Goods)
- Gross Profit
- (minus Operating Expenses)
- Operating Income
- (minus Taxes and Interest)
- Net Income
Each of the expenses above will have parts that are more or less variable from year-to-year.
Companies with more variable expenses can usually cut their expenses easily, making negative net income less of a probability (since they can simply cut those variable expenses when revenues are lower).
Some common variable expenses might be:
- Sales commissions
- Extra advertising spending
Those types of expenses tend to fall under Operating Expenses (“OpEx”), under Selling, General & Administrative (SG&A).
That’s not to say that you can’t have variable expenses only under OpEx however.
A company with heavy expenses to manufacture a product, but whose products are only manufactured after they are ordered, could see huge variance in the number of Cost of Goods (COGs) expenses relative to their revenues.
So when times are good they might have higher COGs, but the total higher volumes make for higher Gross Profits. When times slow down they might have lower COGs, still creating lower Gross Profits due to less volume but not contributing huge losses in Gross Profit which would spill down to losses for Net Income.
Contrast that to a business whose expenses are fixed.
An example could be a restaurant, who has to pay rent and staff regardless if they have 5 customers in their restaurant or 500.
In that case, in times when revenues slow down the company with more fixed expenses will tend to have higher losses, since they can’t just back out these expenses easily.
Key Takeaway: The ratio between fixed and variable expenses can often make the difference between a company who posts negative net income in tough years versus one who does not.
For more on this subject, I recommend this post by Cameron on Operating Leverage (which is the ratio between fixed and variable costs in the Income Statement):
Negative Net Income from Impairments
There is a second type of loss on a company’s Income Statement which is actually non-cash in nature; meaning it doesn’t necessarily represent operating expenses which are higher than operating revenues but does represent losses “on the books”.
I’m talking about asset write-downs, also called Goodwill impairments.
An asset that is written down is one that, basically, loses its value and becomes worth significantly less than it used to (or even, worthless).
You tend to see this a lot with expensive acquisitions.
Say that you were the owner of a lemonade stand and business was great. You’re looking to expand. Maybe you see a lemonade stand in another city which is up for sale. Say they’re selling for $10,000, and earning $1,000 per year. Not a bad price, you think, and so you acquire that business.
In accounting terms, an acquisition is different than an expense.
So on the books, you take your accumulated profits (and maybe cash), pay taxes on those, and use it to acquire the neighborly lemonade stand. It is recorded as a new asset on your books.
But say that the city falls under crime, and the earning power becomes significantly reduced. Maybe after a few years the stand can only earn around $200 a year rather than its usual $1,000.
In that case, your newly acquired business isn’t worth around $10,000 but might actually be worth closer to $2,000.
In accounting terms, you’ll have to realize that loss, and so you record the loss from $10,000 to $2,000 as an $8,000 loss on your books. Write-offs like this hit both the income statement (often leading to negative net income) and balance sheet (reducing the asset value).
This is because in accounting, everything must balance.
When you earn a profit on the P&L (income statement), that’s either paid out as a dividend or added as an asset.
Similarly, when an asset loses value, it must be balanced out with an appropriate loss in the Income Statement—because those previous retained earnings have now turned into a real loss of money.
That’s the basics of asset write-downs, which often take the form of Goodwill impairments for public companies.
A goodwill impairment happens because the accounting for acquisitions says that any price paid to acquire a company above the value of its assets must be recorded as goodwill. If the value of that acquired business is no longer as high, those assets (usually mostly goodwill) must be written-down, or “impaired”.
Again, this hits the income statement, and can cause huge hits to earnings leading to negative net income.
The Implications of Goodwill Impairments
On the one hand, some people will argue that a goodwill impairment is not terrible news because it does not represent true operating (or cash) losses.
In other words, it’s sort of like a spilled milk situation.
The company might still be earning profits on its primary businesses, and this goodwill impairment simply represents past investments (acquisitions) which didn’t turn out.
It’s a valid idea, and its non-cash nature can be confirmed by looking at the cash flow statement and seeing how impairments are added back to Cash from Operations.
However… I think investors need to be careful about dismissing negative net income from goodwill impairments simply because there was no cash truly lost when the write-down occurs.
What a business is signaling when they make a large goodwill impairment is that their previous earnings power is no longer attainable in today’s world. Or, they’re signaling that they previously did a poor job of reinvesting the company’s earnings into an acquisition that would lead to good growth moving forward.
It’s very common for companies to overpay for acquisitions; in fact the statistics back up that M&A tends to happen at overvalued prices more often than not.
In that case, a company is taking profits which could’ve gone back to shareholders in a dividend or buyback and squandering it on an expensive acquisition, which could be adding very little to earning power compared to the price paid for it.
Though it is a sort-of spilled milk situation, investors have to live with the fact that a management that has squandered your money in the past is probably likely to do it again.
“Our experience is once a guy sticks his hand in your pocket, he’ll do it again.”–Chuck Akre
Of course, if there is a new management which has since taken over it might not make sense to hold them accountable for a previous management’s sins; but the damage to compounding for a company regardless of whose fault it is can sometimes be hard to recover from too.
Investors need to weigh the pros and the cons of staying (or buying into) a company with a negative net income due to large asset impairments, and might want to consider staying more weary of those situations than most people tend to be.
Number of Companies with Negative Net Income by Year [S&P 500]
As I like to do with many of the lessons of Wall Street, I like to get historical context with some cold, hard data.
Not to say that the past will predict the future, but to give a base rate of, in this case— how frequently companies get negative earnings in the stock market.
I took the current constituents of the S&P 500 and looked at their Net Income over the last 20 years. Then I added up how many companies had negative net income for each of those twenty (2001-2020).
Here’s what I found, in all its glory:
Note that only current constituents were included, and not those who have been kicked out of the index. So the actual probability of negative net income is probably higher due to the companies who start to perform poorly being the ones usually ejected from the index.
We can see that the percentage of companies who actually post negative net income, even in recessionary periods like 2008, 2009, and 2020, has always been below 20%. That’s pretty infrequent.
Another datapoint I’ve seen batted around before…
Over the lifetime of most stocks, the eventual bankruptcy rate has been around 10%.
Many companies eventually get swallowed up by bigger companies through mergers and acquisitions, and some continue to live on. But somewhere around 10% of public companies go through that worst case scenario of the ultimate failure of bankruptcy.
It makes for some interesting context in how we approach negative net income.
If it really is only as rare as 10% of the time every year for companies, should we readily excuse it when it happens, or respect it as a big potential red flag as I suggested?
What if you had the simplest sell strategy in the world…
“Only sell on negative earnings”.
Your annual rate of turnover would probably be close to 10% over the very long term, which represents an average holding period of 10 years.
That’s great for a long term investor in my book!
You might wonder, sure that’s great, but no company can surely keep from negative earnings… Maybe the 10% is one company for one year and then another for the next… They all have to stumble, right?
Well actually, over those 20 years, here’s how many companies had 0 years of negative net income:
That’s right, fully 40% of companies in the S&P 500 had 0 years of negative net income over a 20 year time period.
So it’s not impossible to find stocks which never post negative earnings.
In fact your chances are pretty decent.
You don’t have to buy a stock with negative net income, even if it may sound like there’s a great reason for that, based on one excuse or the other.
And for a very risk averse investor like me, who insists on buying companies with a margin of safety, emphasis on the safety, well that’s music to my ears. Have a great day!