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Financial Literacy

What are Business Losses?

Many investors are astounded to hear that major companies lose money. They’re shocked to see losses posted for a quarter or a negative figure in the net income column. It begs the question: what are business losses and what, exactly, do they mean?

It starts by understanding the different types of losses, and that some are worse than others. Some losses are bumps in the road on the way to growth. Other losses warrant concern. How they’re reported, what they represent and their place in context all matter. Let’s take a closer look at business losses to better-understand what they mean for a company. 

There are many different types of business losses.

 

Defining a Business Loss

In financial accounting, a business loss is simply the result of more expenses than revenue. The company didn’t bring in enough money to cover its expenses and is thus operating at a loss. Continuing on this trajectory will leave a business insolvent and bankrupt. However, many businesses make the necessary changes to avoid this: reducing expenses, increasing sales, etc. 

As mentioned, there are different types of losses. While the term “business loss” generally refers to an operating loss, there are capital losses, irregular losses and tax losses. 

  • Capital losses are revenue lost through the sale of investments below the purchase price. 
  • Irregular losses are one-time losses that are generally out of the company’s control.
  • Tax losses occur when a company’s deductions exceed accessible income.

Companies may record these different types of losses in very different ways. This creates different tax liabilities and benefits. For example, a business can carry its net operating losses forward indefinitely, while it’s only able to deduct the amount not covered by insurance after an irregular loss. 

Delving into the nature of a loss yields more information about it. Instead of seeing it as a surface loss, investors are wise to look at how it’s categorized and any implications for mitigating that loss. 

Looking at the Profit and Loss Statement

As the name implies, most of a company’s losses show up on its profit and loss statement. If the final figures of the statement are negative, it means expenses outweighed revenue. Companies need to comb through individual expense line items to see where, specifically, costs were higher. Some of the common culprits include: 

  • Cost of goods sold (COGS) expenses
  • Selling, general and administrative (SG&A) expenses
  • Marketing and advertising expenses
  • Technology, research and development expenses
  • Interest expenses

Investors evaluating a company’s balance sheet will pay keen attention to the profit and loss statement, probing deeper to understand where the company is spending and whether that spending is fruitful or reckless. 

“Losses” for Growth Hacking Startups

In today’s public markets, many new companies engage in a practice called growth hacking. The idea is to bring a disruptive product or business model to market and capture as much market share as possible, as quickly as possible, regardless of the expense. Then, once the company becomes ubiquitous, it can begin to realize profits. 

On a balance sheet, growth hacking often shows up in the form of ongoing business losses. Amazon (Nasdaq: AMZN) is perhaps the best historical example of a growth hacking company. Founded in 1994, the company didn’t turn a profit until 2004—even despite revenues in excess of $5 billion at the time. Why? Because it continually ramped up spending on technology, marketing and SG&A, with no regard for profitability. It captured market share by reinvesting in itself and today, as of 2020, the company reports in excess of $21.33 billion in annual income. 

Many other companies have followed or are currently following the growth hacking model, including Netflix (Nasdaq: NFLX), Airbnb (Nasdaq: ABNB) and Uber (NYSE: UBER), among others. 

Net Operating Loss and Tax Implications

Part of the reason growth hacking works—and why it’s often not a surprise for established companies to post business losses—is due to Net Operating Loss (NOL) tax implications. Specifically, NOL carryforward (carryover) rules. 

According to IRS carryforward rules, companies experiencing a net operating loss in one year can deduct that loss from a future year’s profits. In fact, businesses can carry these losses forward indefinitely, so long as they don’t exceed 80 percent of taxable income. This is the fundamental principle behind growth hacking. It’s essentially a way to defer taxes by incurring losses. 

When are Business Losses a Concern?

Business losses become a concern when they’re not the result of positive reinvestment in the company. It’s one thing to spend heavily on R&D to grow market share; it’s another to lose control of COGS and see reduced sales revenues

It behooves companies and investors to closely examine business losses: the reason for them and the amount of the loss. Small losses may not seem problematic, but they will become problematic if they’re indicative of poor operational trends. Conversely, irregular losses may seem dramatic, but they’re easy to put in the rearview mirror—especially if the company has sound operations. 

Business Losses Demand Further Scrutiny

It’s easy to take a business loss at face value. Unfortunately, there’s more to that loss under the surface. Investors who see losses and sell out of a position might be selling themselves short. Likewise, companies that downplay small losses that are the result of operational deficiencies do themselves a disservice. A loss is a loss, but it needs to come with context. Is the company growth hacking? Was the loss an irregular one? Is this part of a larger trend of business losses?

To further advance your financial literacy, sign up for the Investment U e-letter today. Learn about financial accounting, best practices and more!

Qualifying a loss gives it meaning, and it’s an important step in drawing reasonable conclusions about a company’s financial situation. 


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