What is net income and how to calculate it

Importance: Why calculate net income?

Net income is an important calculation because it tells business owners how profitable they were for a specific time period. Investors, lenders and other third parties will inquire about your net income before infusing money into your business. If you are showing a net loss, you might have trouble securing outside financing and investments.

Moreover, consistently generating a net loss can result in cash flow issues and business closure. By frequently reviewing your net income, you can make adjustments to reach your financial and operational goals. One way to adjust your net income is through the creation of a budget.

Furthermore, net income can be a subjective calculation due to the impact of non-cash transactions. For example, revenue recognition principles require companies to report revenue based on when contractual obligations are satisfied.

Altering the amount of deferred revenue your company reports can influence your net income. By analyzing the factors contributing to net income, you can gauge the true profitability and financial health of your business.

Calculation: Calculating net income

Calculating net income is relatively straightforward, involving the subtraction of expenses from gross revenue, also known as gross earnings. Expenses can include different categories, such as cost of goods sold, selling expenses, occupancy expenses, and administrative expenses. The net income formula is as follows:

Net Income = Total Revenue – Total Expenses

It’s also important to differentiate between net income and net income after taxes. Net income after taxes is the net profit remaining after subtracting federal and state income taxes. Generally Accepted Accounting Principles require businesses to report both net income and net income after taxes on financial statements. If your business doesn’t pay income taxes at the entity level, you might not have a separate net income after-tax line item on your income statement.

A positive net income indicates the company made more than it spent, while a negative net income means the company spent more than it earned. Business owners strive to have a positive net income figure.

Remember, net income doesn’t mean cash in the bank, as the calculation can include non-cash transactions, like depreciation and amortization. If you are looking for insights relating to your cash levels, you will need to utilize the statement of cash flows.

Comparison: Net income vs gross income

Net income is not the same as gross income. Gross income, also known as gross profitability, is found by taking gross revenue minus cost of goods sold, which are expenses directly related to the generation of revenue, like raw materials and freight.

On the contrary, net income factors in all expenses of your company for that specific time period, like advertising, office expenses, and insurance. It gives you the bottom-line number on overall operations, while gross income only sheds insights into direct costs.

Furthermore, book net income differs from taxable income. There are often tax addbacks and subtractions that businesses need to take into consideration to calculate taxable income. These can include depreciation adjustments, tax-exempt income, and meals. Book net income is the starting point for calculating taxable income.

In an individual tax setting, gross income, also referred to as “adjusted gross income,” is the total amount of income an individual earns. Then, deductions are subtracted from gross income to generate taxable income. After taxes are calculated and paid, net income is the amount of money left over.

Evaluation: How to improve net income

There are strategies that you implement to improve net profit. First, it’s important to understand which factors are driving your net income calculation. If you had a one-off expense, like the sale of a division or fixed assets at a loss, your net income or loss could be significantly affected. This doesn’t mean that your company as a whole was not profitable, but that you had transactions that were unusual and that impacted your calculation.

If your net income or loss still doesn’t meet your projections after taking into consideration one-off expenses, it’s time to dig deeper into the factors influencing your number. You will need to break apart your calculation by evaluating net revenue and each segment of costs. Does revenue meet your expectations? Were sales lower?

Next, evaluate your costs. Did suppliers increase the price of raw materials? Did the average rate of your payroll increase? Improving your net income relies on uncovering the factors that drive your bottom-line number and figuring out ways to meet your expectations going forward.

In summary

• Net income is a number on the income statement that indicates profitability for a certain period of time.
• Net income is an important calculation to maintain a positive cash flow and promote the financial health of your organization.
• Business owners can improve net income by understanding the factors influencing the calculation, including revenue, cost of goods sold, selling expenses, occupancy expenses, and administrative expenses.