A net loss occurs when a company’s expenses are higher than its total revenue. This can be a sign of problems that need to be addressed. It can, however, also happen because a company has a (relatively) short-term need for more income than it earns.
Examples of net loss
The formula for calculating net loss is the same as for calculating net income. It is:
Total Income - Total Expenses
If the result is a negative number, the company has booked a loss instead of a net profit (if the result is zero, the company has reached the break-even point).
The significance of net loss
What a net loss means in real terms depends hugely on context. In some cases, it is simply down to bad management; in other cases, it’s genuine bad luck. In many cases, it can be a combination of both.
In the case of young companies, however, it can simply reflect the fact that companies often have to spend money before they can earn money. This is particularly true of disruptive companies such as financial technology companies (FinTechs). These often have to deal with huge expenses before they can achieve their first net profit.
Net loss due to bad management
Net losses often start at the top, both literally and figuratively. The lower a company’s gross income, the less income it has to pay its expenses. Low revenue is generally caused by one or both of two reasons. These are incorrect pricing and low sales volume.
Incorrect pricing can lead to low sales volume. Specifically, if prices are set too high, buyers may look for alternatives. However, setting prices too low can also be a mistake. It may drive up sales volumes but this increase may not be enough to counterbalance the increase in the cost of goods sold (or cost of revenue), not even with economies of scale.
Even if the cost of goods sold (or cost of revenue) is kept under control, non-operating expenses may still lead to a net loss. For example, if the sales volume is being driven by marketing, the marketing costs may outweigh the benefit. For completeness, this can sometimes be reasonable in the short term but it is not sustainable in the long term.
Net loss due to bad luck
Company managers are human and sometimes even the best of them simply get caught out by circumstances. When this happens it can be painful in the short term. If a company has solid management, however, the managers will assess the situation quickly and set out a path for adapting to it and returning to positive net income.
Net loss due to a short-term need for income
All businesses have start-up expenses that need to be met before they can start to earn any revenue. In some cases, those expenses may be so small that they may not even be noticed. For example, new freelancers may not think of using their personal computer for work as a business expense.
In other cases, start-up and scale-up expenses can be so big that they consume all of a company’s profits literally for years. Probably the most famous example of this is Amazon. The internet giant was founded in July 1994 but it only recorded its first profit in January 2004. This is related to the last quarter of 2003.
Since then, however, the company has gone from strength to strength. It also looks certain to turn in robust net income figures for many years, if not decades, to come. As a result, its early backers who stood by it while it grew have been richly rewarded for their patience.