Unveil the significance of calculating net income for business profitability, a key indicator for financial health and decision-making. Understand the formula and practical applications for determining net earnings.
By Brad Nakase, Attorney
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A company’s net income, often known as its “net earnings,” “net profit,” or just “profit,” is a measurement of its profitability. A business has a net loss when it experiences a loss of revenue. In accounting, net income counts as the most significant figure after revenue.
Have you ever heard a person describe a company as being “in the black” or “in the red”? This is because accountants used to record net income in black ink and net loss in red ink.
While a lot of small companies wait to calculate their profitability until compelled to do so by an investor or lender, tracking your net income is one of the most effective ways to keep an eye on your company’s financial situation.
You’re most likely heading in the correct direction if your net income is rising. Cuts might be necessary if it isn’t.
It’s a crucial statistic for investors and lenders alike. The goal of lenders is to ensure that you have sufficient funds to settle all of your debts. Investors are interested in knowing how much cash the company will have left over to fund dividend payments, further invest in the company, or put away for another day.
For the time being, let’s go straight into using the formula for net income to determine net income.
The entire profits of your business after all business costs are subtracted is known as net income. Net income is sometimes referred to as net profits, net earnings, or just your “bottom line” (so-called because it’s at the end of the income statement). It’s the quantity of money left over after paying debts, paying shareholders, investing in new ventures or machinery, and setting money aside for future needs.
One of the three primary financial statements that business owners must prepare is an income statement. The purpose of an organization’s income statement, sometimes known as a “profit and loss statement” or “p&l,” is to demonstrate how net income was determined.
The following formula is used to get net income:
Net Income = Revenue – Cost of Goods Sold – Expenses
The equation for gross income is the same as the first component of the formula, which is revenue less cost of goods sold.
Stated differently, the equation for net income is:
Net Income = Gross Income – Expenses
Alternatively, if you truly want to streamline things, the net income formula can be written as follows:
Net Income = Total Revenues – Total Expenses
Net income may be either negative or positive. Your business has a positive net income when its revenues exceed its expenses. If all of your expenses exceed your revenue, you have a negative net income, often referred to as a net loss.
You may find your firm’s net income for any specific period—monthly, quarterly, or annual—using the method above. You can choose the timeframe that works best for your organization.
Assume for the moment that Lana’s Shoe Store wishes to determine its net profits for the 2023 first quarter. The numbers that Lana is utilizing are as follows:
Total revenues: $70,000
Cost of goods sold (COGS): $30,000
Rent: $7,000
Utilities: $3,000.
Payroll: $11,000
Advertising: $2,000
Interest expense: $2,000
Lana might first determine her gross income by deducting COGS from her entire revenues:
$70,000 – $30,000 = $40,000 is the gross income.
Lana then tallies her quarter’s worth of spending.
Expenses come to $25,000 ($7,000 + $3,000 + $11,000 + $2,000 + $2,000).
By deducting expenses from her gross revenue, Lana may now determine her net income:
$40,000 – $25,000 = $15,000 is the net income.
Lana made $15,000 in net income during the quarter.
It’s critical to distinguish between net and gross income. Gross income, often known as gross profits or gross earnings, is the sum of your sales less the direct costs incurred in providing your goods or services, or COGS. This is represented in equation form:
Revenue – Cost of goods sold (COGS) = Gross income
COGS for your company are often found right under revenues at the beginning of your income statement.
Typical COGS examples include the following:
Remember that indirect expenses, sometimes referred to as “overhead,” “operating costs,” or “operating expenses,” are not included in COGS. Salaries for managers, lawyers, accountants, administrative costs, insurance, utilities, and interest are examples of these running expenses.
Beyond gross income, operating income is an additional, more cautious indicator of profitability. Operating expenses, commonly referred to as Selling, General, and Administrative (SG&A) expenses, are any out-of-production costs incurred by a business. Non-operating expenses like taxes, interest, depreciation, and amortization are not included in operational expenses.
The operating income formula is:
Gross income – Operating expenses = Operating income
The three most widely used methods of determining a company’s profitability are net income, operational income, and gross income. Further, these methods are interrelated.
When all three formulas are written out, it becomes clear that gross profit, operational income, and net income are distinct but progressively more cautious metrics of profitability for a certain accounting period:
Gross Profit = Revenues – COGS
Operating income = Revenues – COGS – Operating expenses.
Net income is calculated as revenues – COGS – operating expenses – non-operating expenses.
Have you noticed that the operating, non-operating, and COGS expense categories are all included in the net income equation? This is because it is our most trustworthy and conservative indicator of profitability.
Operating net income is an additional helpful net income metric to monitor. Net income and operating net income are related. Nevertheless, it only considers an organization’s operating profitability, leaving out revenue and costs unrelated to the main business operations. This can include losses or gains from the sale of fixed assets, income tax, interest expense, and interest income.
EBIT, or “earnings before interest and taxes,” is another term for operating income.
The operating net income formula is as follows:
Operating Net Income = Net Income + Taxes + Interest Expense
Otherwise expressed, operating net income can be calculated as:
Operating Income = Gross Profit – Operating Expenses – Depreciation – Amortization
Sometimes operating net income is more appealing to lenders and investors than net income. This helps them determine the profitability of the company’s main business operations.
For instance, a business may be losing money on its main business activities. However, the gain from the sale of an expensive piece of machinery will be factored into the business’s net income. That profit could give the impression that the business is doing well while, in reality, they’re having trouble making ends meet.
Operating net income excludes the gain, giving viewers of the financial statements a more accurate representation of the company’s performance and valuation.
One can obtain this information from a cash flow statement. Find out why cash flow statements are the best report to use when assessing a company’s health.
Let’s go back to Lana’s Shoe Store. Lana only needs to add the interest expense back to his net income in order to get her operating net income for the first quarter of 2021.
$17,000 operational net income is equal to $15,000 net income plus $2,000 in interest expenses.
If your bookkeeping is up to par, determining operating net income and net income is simple. If so, your net income is probably already shown in an income statement or profit and loss statement that you already have. Prior to adding other income and expenses to get net income, your company’s income statement may even isolate operating net income as a separate line item.
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