Net income – a term that’s also known as the bottom line – is a financial metric within business accounting that reflects the profitability of a business after all their operating expenses, taxes and other costs have been deducted from the total revenue.
To think of it another way: it’s the most comprehensive measure of a company’s financial performance. That’s why it’s so often used by business owners, investors and lenders to figure out a company’s profitability and operational efficiency.
Net income defined
At its core, net income is the amount of profit a business earns over a specific accounting period. It’s calculated using the following formula:
Net income = Total revenue – Total expenses
Total business expenses tend to include the cost of goods sold (COGS), operating expenses, interest, taxes, depreciation and amortisation. The result shows the earnings available to owners and shareholders, or the amount for reinvestment in the business.
How to calculate net income
Before taxes you’ll have an idea about the company’s gross income. Here are five easy steps for calculating net income:
- Start with total revenue: Including income from all sources, such as sales or services provided.
- Subtract cost of goods sold: COGS covers direct costs like raw materials, production labour, inventory and more. The result is gross profit (not net profit).
- Deduct operating expenses: This includes salaries, rent, utilities, marketing and other administrative costs.
- Factor in non-operating expenses: Subtract interest on loans, one-time expenses or other miscellaneous costs.
- Subtract taxes: Account for tax obligations with the regular income statement in order to arrive at the final net earnings figure.
Example calculation
Let’s say a company earns $500,000 in total revenue during the year. Its expenses include:
- COGS: $200,000
- Operating costs: $150,000
- Company’s income statement: $20,000
- Income taxes and other taxes: $30,000
Net income = $500,000 – ($200,000 + $150,000 + $20,000 + $30,000) = $100,000
Therefore, the business’s net income for the year is $100,000.
Why is net income important?
- Company’s profitability: Net income helps measure whether a business is profitable or operating at a loss. A positive net income shows profitability, whereas a negative net income (net loss) shows the business is spending more than it earns.
- Financial health: Net income gives insights into a company’s overall financial performance and administrative expenses. In other words, it shows whether the business has the ability to manage their expenses smartly.
- Decision-making: Business owners use the company’s net income to guide decisions on reinvestment, cost management, dividend distribution and more.
- Attracting investors and lenders: Investors tend to look at net income and other financial statements to evaluate growth potential, while lenders look at it to determine creditworthiness.
Net income vs gross profit
While gross profit focuses on the profitability of core operations (revenue minus COGS), net income accounts for all expenses. The result? A more complete picture of overall profitability. For example, a company might have a strong gross profit but still report a negative net income on their cash flow statement due to high debt or operating costs.
Limitations of net income
Net income doesn’t represent things like cash flow or just sales revenue. Non-cash expenses like depreciation and accrual-based accounting can have an impact on net income, which means it’s less useful as a standalone metric. Pairing it with cash flow analysis will give you a fuller picture of a company’s overall financial health.
