Financial reports, or financial statements, include a balance sheet (statement of financial position), income statement (P&L or statement of comprehensive income), statement of changes in equity (statement of retained earnings) and cash flow statement. The bottom line of the income statement is net income. This is why many people may want to ask: "what is net income"?
The answer to the question "what is net income" is simple, but the implications are complex. It is the number found on the bottom of the income statement, representing the difference between revenue and expenses. The calculation itself is simple. What takes a little analysis is determining why it is what it is and how it can be improved. It is not the best indicator of financial health, but it is one many shareholders, managers, owners and auditors look at. It is a key indicator of the need to further investigate your company's finances and an important part of critical financial ratios.
What Is Net Income?
What is net income? Net income, also known as net profit, are the total profits of your company after deducting expenses. This is sometimes referred to as net earnings or your company's bottom line. This number can be either positive or negative. A negative net income, sometimes called a net loss, occurs when your business has more expenses than revenues. A positive net income means your company generated more revenues than it incurred in expenses. Business expenses include operating expenses, payroll costs, rent, utilities, taxes, interest, certain dividends and more.
What Is Gross Income?
It is crucial you know what is net income, but as a business owner, you also need to know gross income. Gross income, sometimes referred to as gross profit, reflects how much your business has before deducting all the expenses. To calculate gross income, subtract your company's gross income (revenue) by your cost of goods sold (COGS). COGS represents the amount it costs you to produce a product or perform a service.
What Is Net Income Used For?
Net income can be used for a variety of business activities. If your business is a sole proprietorship or a limited liability corporation where you are the owner and only employee and shareholder, you can use the net income to perform an owner's draw. This is you paying yourself back a portion of the money you initially invested in or lent, the company.
Net income can be used to pay off high-interest debt, invest in new projects or pay dividends to shareholders. Investors, creditors, and management focus on the net income calculation because it gives a good idea of whether or not the company can efficiently manage its assets and if it is in a strong financial position.
Creditors want to know a company is fiscally sound enough to pay off any debts with successful operations. If your business does not have a credit score because it has never had a credit card or other business loan, creditors will look at your net income to make a determination of your creditworthiness. Your net income may result in them offering you a larger loan amount or lower interest rate, if you have a high-profit margin compared to other companies of similar size in your industry. New lenders may also request proof of good faith payments to vendors who supply your goods or your utility companies.
Net income often drives the dividends returned to shareholders and has a positive relationship with stock price. Investors want to see companies have the income to pay their dividends and the company is growing at the expected rate so share price will rise. If you are a shareholder, look closely at both the P&L and balance sheet. It may be the company's cash position is weakening because they are recording assets rather than expenses or prepaying expenses (also an asset).
Why Is it Important?
Why is net income one of the most closely inspected numbers in finance? Net income plays a huge role in financial statement and ratio analysis. Shareholders want to see a strong positive net income, as it tends to drive their main compensation source through share buybacks and dividends. If a company has a poor net income and cannot adequately compensate stakeholders, the share value of the company will plummet. On the other hand, higher stock prices will reflect the increased availability of profits when a company is growing at a healthy clip.
The bar on your street corner can have a 20% profit margin but only $100.00 in net profit, while a software company can have a 1% profit margin but a net profit of $1,000,000. This is why it is essential to look not at only what is net income, but also the profit margin (net income as a percentage of sales) or the price-to-earnings (P/E) ratio.
The second formula tells investors how much they are paying for each dollar of net income the company generates. This may not always be as useful as looking at the profit margin of a company. Because profit margin is based on sales, it eliminates irrelevant, large one-time influxes in cash such as law settlements or government assistance.
A lower-than-expected net income or profit margin alerts you to the fact you may need to take a closer look at your company's operations. Did your company have $80,000 in gross sales but take back $20,000 in returns? You may need to look at your quality control or seek out better vendors for supplies. Did you pay five years in back taxes plus failure to file penalties, fees, and interest? The culprit may not be your operating margin but the quality of the finance and accounting staff you employ or outsource.
Management and owners are interested in net income from the standpoint of they need to satisfy both creditors and investors. It also indicates that they need to improve or eliminate existing processes or continue with the changes that were made to improve net profit. A sole proprietor can know how much to withdraw weekly, monthly or quarterly or how much to put in a savings account. A partnership will divide the net profits based on the percentage of ownership each partner has. Corporations use the net profit to pay their shareholders dividends.
The government is very interested in your company's net income. Pre-tax profit, or net profit earned before taxes, is the basis of calculating income taxes the Internal Revenue Service collects. Net profit is calculated as net profit before taxes.
If your competitors are publicly traded companies, you can look at their profitability and operational efficiency and see how your company stacks up. If your competitor generates roughly the same sales revenue as you but has a much higher profit margin, you may want to look at finding new vendors or other ways to reduce your costs.
How to Calculate Net Income?
As important to know what is net income is, understanding how to calculate this critical piece of data is just as important. To calculate net income, subtract expenses from your gross income. Gross income is your Cost of Goods Sold minus your revenue, so the formula for calculating net income is revenue minus cost of goods sold minus expenses.
What about Personal Net Income?
People look at their personal net income in a couple of ways. The most obvious is the line on their paystub that says "net income." This refers to how much they get paid after FICA, state, local and federal taxes and other benefits or expenses are deducted. Benefits deducted from your paycheck can include health insurance or pre-tax retirement investments such as a 401k or 403(b). Expenses can include past-due taxes or child support or higher education wage garnishments if you fail to pay back your student loans.
More interesting is personal net income as it relates to an individual's earnings (revenue) versus expenses and bills. You can calculate your personal net income on a cash basis, recognizing earnings when you get the cash in hand and incurring expenses as they get paid. Alternatively, you can calculate your personal net income on an accrual basis.
This means, if you prepay your rent for a year, rather than having a $12,000 expense this month, you reflect the $1,000 rent payment each month when it is due. Similarly, if your roommate pays you their portion of the utilities a year in advance, you would recognize the revenue in the month the corresponding bill is dated. For example, if you have a $40 water bill due 5.28 and you pay it 6.6, you would recognize the $20 income from your roommate in the same month the bill was generated.
What is net income can mean different things in different circumstances? It can be used to determine how profitable a business is and inspected by the government, lenders, creditors, management, owners, and competition. It can also be used on a personal level to determine the financial health and standing of an individual or household.
You may choose to calculate your net income on a cash or accrual basis. Net income can also refer to how much of your paycheck you receive each pay period which is important to many individuals. Whatever application you use the calculation of net income for, remember it boils down to income minus expenses.