Wondering if your business is making money, breaking even, or heading into the red? Knowing how to calculate net income is the key to understanding your company’s financial health.
Not only does net income tell you what is left after you subtract your expenses from your revenue, but this key figure is also used to calculate a number of profitability ratios. Understanding your business’s net income can be the key to increasing your profits.
Read on for an easy-to-understand guide on net income, complete with real-world examples and actionable advice!
What is net income and why does it matter?
Net income is one of the simplest business metrics to calculate.
You’ve likely heard net income referred to as the bottom line. That’s because it is most often the last line of your income statement.
The basics: What is net income?
Net income is the money your business has left after all expenses are accounted for.
It’s not to be confused with other terms such as ‘gross profit’ or ‘operating income’, which we’ll delve into later.
In the simplest terms, net income is your total revenue minus all your costs, taxes, and operating expenses.
Gross profit is the number you get when you take your revenue and subtract your cost of goods sold (COGS). It is calculated at a different stage of the income statement than net income. Not all types of businesses have COGS. In that case, those businesses don’t show gross profit on their income statements.
Operating income is another common term you may have heard before. It differs from net income as well.
Operating income consists of the income generated from the core operations of a business. This would not include activities such as interest payments, taxes, and other non-operating revenues and expenses.
Net income, on the other hand, includes all revenues and expenses of the business regardless of whether they form part of the main operating activities. Once again, we see why net income is often referred to as the bottom line.
But remember, there is a clear distinction between gross profit, operating income, and net income.
Why is net income crucial?
Understanding your net income is vital for a multitude of reasons that span various aspects of business management and strategy. First and foremost, net income guides business decision-making by providing crucial information on whether to expand or cut back.
If you’re consistently seeing positive net income figures, you might consider scaling your operations, hiring more staff, or increasing marketing activities. On the flip side, a low or negative net income may necessitate cost-saving measures.
Secondly, lenders and investors closely scrutinize your net income before deciding to extend loans or make investments. A strong net income suggests your business is less risky and more likely to provide a return on their investment.
Lastly, net income plays an essential role in planning and growth strategies.
It offers a clear financial snapshot of where your business stands, allowing for more informed and effective planning for the future. Overall, net income serves as a fundamental pillar in shaping your business’s financial health and strategic direction.
The nitty-gritty: How to calculate net income
Net income is shown on the income statement, but it also flows through to the balance sheet.
Many businesses have a separate statement of retained earnings (or owner’s equity if the business isn’t incorporated). This statement starts with the previous year’s retained earnings and adds the current year’s net income (or subtracts a net loss) to calculate retained earnings for the current year.
What’s on a balance sheet? Understanding assets and liabilities
A balance sheet provides a snapshot of your business’s financial position, showing what you own (assets) and what you owe (liabilities).
Although net income is not directly calculated on the balance sheet, understanding these components helps you comprehend how income flows through your business.
The current year’s retained earnings or owner’s equity, which includes the net income or net loss for the year, is shown on the balance sheet in the equity section. So while there isn’t a separate line on the balance sheet to show net income, it’s still included on the balance sheet as part of equity.
The net income formula: Breaking down the equation
As mentioned previously, the net income formula is quite straightforward. It is:
Net Income = Revenue − Expenses
In this formula, expenses can include everything from the cost of goods sold (COGS) to operating expenses, interest, and taxes. The net income equation is a condensed version of the accounting income equation, providing a direct way to determine net income or loss.
The accounting equation is: Equity = Assets – Liabilities
We see this equation in use on the balance sheet, and it’s how we make sure the balance sheet is balanced.
Another way to write the accounting equation is: Assets = Liabilities + Equity.
Remember, net income forms part of equity.
Accrual vs cash: How to calculate net income on an accrual basis
The good news is it’s just as easy to calculate net income whether your business uses the accrual or cash method of accounting. The formula is exactly the same.
What’s different is how you record your revenue and expenses.
- In cash accounting, you record revenue when you receive the payment and you record expenses when you pay for them.
- In accrual accounting, you record revenue when it’s earned and you record expenses when they’re incurred.
With accrual accounting you will have accounts receivable (the payments owed to you by customers) and accounts payable (the amounts you owe your suppliers).
In cash accounting, these two accounts are unnecessary because everything is recorded at the time of the transaction.
To ensure your net income calculation is accurate when using accrual accounting, you’ll need to ensure your revenue and expenses are recorded in the period they are earned or incurred, not when the cash is actually received or paid.
Real-world examples: Net income in action
Whether you’re a seasoned entrepreneur or just getting started, understanding net income through tangible scenarios can be a game-changer for your financial planning and decision-making processes.
Here are two examples that bring the abstract numbers and formulas into everyday business reality.
Sarah owns a bakery. Her total revenue for the month is $10,000. She pays $2,000 for ingredients (COGS), $1,000 for rent and utilities (operating expenses), $200 for loan interest, and $1,500 for taxes.
Using the net income formula, Sarah’s net income would be:
Net Income = 10,000 – (2,000+1,000+1,500+200) = $5,300
Sarah can use this net income figure for multiple purposes such as securing additional loans, making investment decisions, or planning expansion strategies.
Green Dreams’ fluctuating expenses
Green Dreams is a landscaping business that has higher revenue in the spring and summer due to the peak gardening season.
During these months, it earns $50,000 in revenue and its COGS, primarily soil, plants, and labor, amounts to $20,000.
Its operating expenses, including office rent, utilities, and marketing, is $10,000.
That leaves the business with a net income of $20,000 [50,000-(20,000+10,000)].
Let’s take a look at how this compares to the off-season.
During the slower times of the year, Green Dreams has $20,000 in revenue but still has similar costs for COGS and operating expenses, totaling $30,000. In this case, the net income would be negative, at -$10,000.
When net income is negative, it’s referred to as a loss or net loss.
This example underscores the importance of closely managing expenses and planning for seasonal fluctuations when calculating net income. It also emphasizes the need for a well-thought-out marketing and operational strategy to balance out the highs and lows throughout the year.
Keeping an eye on your net income in this context can provide actionable insights for better financial management and long-term sustainability.
Common pitfalls and how to avoid them
When calculating net income, it’s important to do so correctly to avoid mistakes. Calculation errors in net income can easily lead to errors in other formulas that use net income as part of their calculation.
Not accounting for all expenses
If you are properly tracking your income and expenses through a business credit card and a business bank account which you only use for business transactions, you will be more likely to have accounted for all your business expenses.
However, it’s still possible to miss items, especially if the business owners are in the habit of paying for expenses with their personal funds.
If this does happen, you’ll want to make sure you have a method for tracking these expenses, so they aren’t missed when net income is calculated.
For example, let’s refer back to Sarah’s Bakery.
Sarah is the owner, and she runs out of sugar one day. Since she can’t afford to close her bakery and wait for her next shipment to arrive, she runs to the closest grocery store. But because she was in such a rush, she forgot her business bank card, so she pays for the sugar using her personal credit card.
If Sarah doesn’t make a note of this, so it is properly recorded by her bookkeeper, her net income will be overstated because her financial statements won’t include the amount that she purchased using her personal credit card.
This is an important argument for keeping track of personal and business funds separately. It’s much easier to keep track of things when you know all the charges are business related.
Confusing cash flow with income
Cash in the bank isn’t the same as net income.
You can’t look at your bank balance and report that amount as your net income on your tax return.
Understanding the difference between cash flow and net income is crucial for business owners. While both are important indicators of a business’s financial health, they measure different things and can tell very different stories about how a business is doing.
Let’s compare cash flow and net income for the same month for Sarah’s Bakery:
In January, her revenue for sales of baked goods was $10,000. Her COGS—ingredients, baking supplies, etc.—amounted to $3,000, and her operating expenses (utilities, rent, employee wages) were $4,000. This left her with a net income of $3,000 for the month of January calculated as 10,000-(3,000+4,000).
Now, let’s consider her cash flow.
Sarah had to buy a new oven in January, which cost her $1,500. She also received a payment of $2,000 from a catering job she completed in December. Starting with her January net income of $3,000, we subtract the cost of the new oven ($1,500) but add the late payment received ($2,000). Sarah’s cash flow for January is $3,500 (3,000-1,500+2,000).
While Sarah paid for the oven in January, it doesn’t impact her net income because capital assets are not treated the same way expenses are. The catering job would have been recorded as revenue and calculated as part of Sarah’s December net income since that is when she performed the work.
As you can see, while net income and cash flow are related, they measure different things, and it’s important to understand how each is calculated.
Additional terminology: What is net earnings and net profit?
You may hear terms such as net earnings or net profit in addition to net income.
These terms are often used interchangeably with net income, and all three represent what you will commonly hear referred to as the ‘bottom line’.
Final thoughts: The bottom line
In the world of business, net income isn’t just a term, it’s a measure of success, growth, and sustainability.
Understanding how to calculate it, interpret it, and apply it to your business decisions is crucial.
Now you’re equipped with this knowledge, you’re one step closer to steering your business toward financial success.
Remember, net income is more than just a number on a piece of paper. It’s a powerful tool that can help you make informed business decisions, secure loans or investments, and plan for the future. Keep an eye on it, and it could be your key to unlocking endless possibilities for your business.
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