Net income serves as a crucial metric in assessing a business’s financial health. By subtracting all expenses, taxes, and interest from total earnings, net income offers insight into a company’s profitability.
Net income, also known as “net profit,” “net earnings,” or simply “profit,” stands as a pivotal indicator of a company’s profitability. It represents the surplus remaining after deducting all expenses from total revenue. Conversely, a net loss occurs when a business experiences a shortfall. In accounting, net income holds significant importance, second only to revenue.
Have you ever heard the terms “in the red” or “in the black”? These phrases originate from accounting practices where accountants traditionally recorded net losses in red ink and net income in black ink.
Understanding the Significance of Net Income in Financial Analysis
To improve financial health and meet the expectations of lenders and investors, tracking net income is crucial for small businesses. Increasing net income signals progress, while stagnant or declining figures may necessitate cost-cutting measures. Lenders rely on it to assess debt repayment capacity, while investors gauge potential dividends or reinvestment opportunities.
Now, let’s delve into the net income calculation using the net income formula.
Net Income Formula in an Infographic
Calculating Net Income: A Simple Formula Explained
Net income, often termed as net profit or bottom line, signifies your company’s ultimate profitability after accounting for all expenses. It’s the sum available for various purposes like shareholder dividends, investments, debt repayment, or reserves.
To determine net income, businesses prepare an income statement, also known as a profit and loss statement (P&L). This financial statement illustrates how net income is derived.
The formula for net income is straightforward:
Revenue – Cost of Goods Sold – Expenses = Net Income
Alternatively, considering that revenue minus cost of goods sold equals gross income, the net income formula can be simplified:
Gross Income – Expenses = Net Income
In even simpler terms, the formula can be expressed as:
Total Revenues – Total Expenses = Net Income
Net income can be either positive or negative. Positive net income indicates that your revenues surpass expenses, while negative net income, termed as a net loss, occurs when expenses exceed revenues.
By applying this formula, businesses can calculate their net income for any chosen period—be it annually, quarterly, or monthly—suitable to their operational needs.
Example Calculation of Net Income
Let’s illustrate the net income formula using an example from Wyatt’s Saddle Shop for the first quarter of 2023. Here are the relevant figures:
- Total Revenues: $60,000
- Cost of Goods Sold (COGS): $20,000
- Rent: $6,000
- Utilities: $2,000
- Payroll: $10,000
- Advertising: $1,000
- Interest Expense: $1,000
First, Wyatt determines his gross income by subtracting the COGS from total revenues:
Gross Income = $60,000 – $20,000 = $40,000
Then, Wyatt calculates his total expenses for the quarter:
Total Expenses = $6,000 + $2,000 + $10,000 + $1,000 + $1,000 = $20,000
Finally, Wyatt computes his net income by subtracting total expenses from gross income:
Net Income = $40,000 – $20,000 = $20,000
Therefore, Wyatt’s Saddle Shop achieved a net income of $20,000 for the first quarter of 2023.
Comparison: Net Income vs. Gross Income
It’s crucial to differentiate between gross income and net income. Gross income, also known as gross earnings or gross profits, represents your revenues minus the cost of goods sold (COGS), which are the direct expenses associated with producing your goods or services.
Mathematically, it’s expressed as:
Gross income = Revenue – Cost of Goods Sold (COGS)
Typically, you’ll find the COGS listed near the top of your income statement, just below revenues.
Examples of COGS include:
- Raw materials
- Labor costs
- Packaging, freight, and shipping expenses
- Energy and utility costs for production facilities
- Depreciation expenses on production equipment and machinery
It’s important to note that COGS excludes indirect expenses, also known as overhead, operating costs, or operating expenses. These expenses encompass items such as salaries for professionals like lawyers and accountants, management fees, administrative expenses, utility bills, insurance premiums, and interest payments.
Net Income Relationship with Operating Income
Operating income presents a more conservative assessment of profitability compared to gross income, as it encompasses not only gross income but also operating expenses, also known as Selling, General, and Administrative (SG&A) expenses. Operating expenses encapsulate any costs incurred by a company that are unrelated to production, excluding non-operating expenses such as interest expenses, taxes, amortization, and depreciation.
The formula for operating income is:
Operating income = Gross income – Operating expenses
Gross income, operating income, and net income are the three primary metrics used to gauge a company’s profitability, and they are interrelated. By examining all three formulas, we can discern how gross profit, operating income, and net income differ yet represent increasingly conservative measures of profitability over a given accounting period:
- Revenues – COGS = Gross profit
- Revenues – COGS – Operating expenses = Operating income
- Revenues – COGS – Operating expenses – Non-operating expenses = Net income
Note that the net income equation encompasses all three major expense categories: COGS, operating expenses, and non-operating expenses. This comprehensive approach makes net income the most conservative and reliable measure of profitability available.
Operating Net Income Formula
Operating net income, akin to net income, focuses solely on a company’s profits from its core operations, excluding income and expenses unrelated to its primary business activities. This excludes items such as income tax, interest expense, interest income, and gains or losses from sales of fixed assets.
Operating income is sometimes denoted as EBIT, or “earnings before interest and taxes.”
The formula for operating net income is:
Net Income + Interest Expense + Taxes = Operating Net Income
Alternatively, operating net income can be calculated as:
Gross Profit – Operating Expenses – Depreciation – Amortization = Operating Income
Investors and lenders often prefer to analyze operating net income over net income as it provides a clearer indication of a company’s profitability from its core operations.
For instance, a company might incur losses in its core operations but realize a significant gain from selling an asset. While this gain inflates net income, it doesn’t accurately reflect the company’s operational performance. Operating net income excludes such gains, offering stakeholders a more accurate assessment of the company’s profitability and valuation.
This information can typically be found in a company’s cash flow statement, which is essential for understanding its financial health and performance.
Understanding Operating Net Income: Calculation and Example
 Let’s delve into an illustration using Wyatt’s Saddle Shop. To compute his operating net income for Q1 2021, Wyatt would simply incorporate the interest expense into his net income.
$20,000 net income + $1,000 interest expense = $21,000 operating net income
Calculating both net income and operating net income becomes straightforward with efficient bookkeeping. If you maintain accurate records, you likely possess a profit and loss statement or income statement detailing your net income. Review our guide for a comprehensive understanding of income statements. Your company’s income statement may even delineate operating net income as a distinct line item before amalgamating other income and expenses to determine net income.
Income Statement Line Item Overview at PVM Accounting
Net income stands as a crucial line item on your income statement, offering insights into the inflow and outflow of funds within your business on a monthly basis. At PVM Accounting, we empower small businesses with comprehensive financial reports, including income statements, derived from meticulous bookkeeping practices.
Our team ensures that your monthly books are accurately maintained, allowing us to generate detailed financial statements tailored to your business needs. Through PVM Accounting, you gain access to user-friendly reports that shed light on your financial landscape, including income statements, balance sheets, and visual representations of your financial data.
With our services, you can effortlessly track your business’s financial activities, enabling you to make informed decisions and drive growth. Say goodbye to uncertainties about your business’s financial health and welcome clear, actionable insights that propel your business forward. Begin your journey with PVM Accounting today by requesting a complimentary accounting quote.
Here’s an example income statement for Coffee Roaster Enterprises Inc., with net income listed at the very bottom:
This content is intended for informational purposes only and should not be construed as legal, business, or tax advice. It is recommended that individuals consult with their own attorney, business advisor, or tax advisor regarding the specific matters discussed in this content. PVM Accounting bears no responsibility for any actions taken based on the information provided herein.
