Net income is one key metric that you can use to assess your business’s financial health. It’s the bottom line on your income statement, also called a Profit & Loss Statement (P&L), and it tells you how much money you have remaining after deducting your costs and operating expenses from your total Revenue.
What Is Net Income?
Net income can be compared to “take-home pay” for an employee. It’s the amount of money remaining after taxes, insurance, and other expenses are deducted from your total pay or gross income. It’s essentially the ultimate profit figure that indicates the true profitability of a company.
Similarly, the net income for a business is the amount of money remaining after deducting all business expenses, including wages, interest, product costs, operation costs, and taxes. Net income, also known as the bottom line, net earnings, or net profit, appears at the bottom of income statements.
Generally, a healthy, growing business will have net incomes that are positive and increasing consistently. In other words, the more you increase revenue and decrease expenses, the healthier you are.
The net income or net loss of your business may also show up on your balance sheet as retained earnings. Retained earnings are the amount of money that is held (not distributed to shareholders)
How Do You Calculate Net Income?
The net income formula helps calculate the net income of either an individual or a business.
For individuals, calculating net income is fairly straightforward. You take the total amount earned (gross income) and then deduct all expenses, such as interest payments and taxes. For a business, it is a little more complicated.
Net Income Formula
Businesses can use the net income formula to calculate net income for any timeframe. There are two primary ways to calculate net income–using revenue and expenses or gross profit and expenses. We’ll go over each net income formula and how to use them.
Total Revenue
This includes all the money a business earns from its primary operations. It encompasses sales, fees, or any other sources of income.
Total Expenses: These are the costs associated with running the business. They can be categorized into various types, such as operating expenses, interest expenses, and taxes.
Cost of Goods Sold
COGS is the cost of the product or the service being delivered. If you have a t-shirt company, it is the wholesale cost of the t-shirt, plus freight, labor, and printing costs. If you provide consulting services, it is the cost of labor to provide the consulting.
Gross Profit
Gross profit represents to profit made on the sale of the product or service. This provides insight into whether your pricing is bringing you the profit desired on each sale.
Gross Profit=Revenue – Costs of Goods Sold
Operating Expenses
Operating expenses are the costs of running the day-to-day business including advertising & marketing, rent, payroll, insurance, software, website, postage, auto expenses, meals, travel, and more. These are the below-the-line (Gross Profit) costs.
Net Income
- Net Income = Gross Profit – Operating Expenses
It’s important to note that net income can actually be a net loss. If your operating expenses exceed your gross profit, it results in a net loss. When your operating expenses are less than your gross profit, it results in net income.
Often, when a business is in start-up mode, a net loss is not surprising. Although there is a tax benefit to a Net Loss, it doesn’t lead to a sustainable or scalable company without further investment.
It’s also important to note that net income may include revenue that does not come from your core business activities. For example, if your business owns real estate and rents out part of it, or you gain royalties from a past partnership. This is generally referred to as non-operating income.
Business Net Income Example
To fully understand the net income formula, let’s look at a hypothetical business scenario.
Kingsley Marketing Agency wants to calculate its net income for the fourth quarter. Here are the necessary figures to calculate net income from its accounts:
Cost of goods sold (COGS):$5,000,000
- Rent: $50,000
- Utilities: $10,000
- Payroll: $150,000
- Advertising: $50,000
- Interest expense: $50,000
- Total Revenue: $10,000,000
According to the net income formula, Kingsley Marketing Agency first needs to calculate Gross Profit. You would do this by subtracting the costs of goods sold, including direct labor costs, from the total revenue.
- $10,000,000 (Total Revenue) – $5,000,000 (COGS) =
$5,000,000 (Gross Profit)
- $75,000 (Rent) + $10,000 (Utilities) + $150,000 (Payroll) +
$50,000 (Advertising) + $50,000 (Interest Expense) =
$335,000 (Total Expenses)
With all these results, Kingsley Marketing Agency can now calculate its net income. To do this, you use the net income formula and subtract total expenses from gross income.
$5,000,000 (Gross Income) – $335,000 (Total Expenses)
= $4,665,000 (Net Income)
Overall, the fourth quarter’s net income for Kingsley Marketing Agency is $4,665,000.
Cash Flow vs. Net Income
These are simplified explanations of how to calculate net income. However, net income does not equate to how much money is in the bank. We often hear questions like, “I made $100,000 this year, but why don’t I have $100,000 in the bank.” That is because cash flow is very different from net income.
Factors like credit cards, business loans, owner’s payments, or investment income affect the money in the bank but aren’t factors in net income. You can learn more about cash flow vs. profit and how to use cash flow for decision-making in our blog. If you do not know how to calculate, click below and contact us.
Individual Net Income Example
Looking at an individual net income example can help you better understand how it differs from calculating the net income for a business.
Let’s consider Mike, an employee working as an Analyst. Mike receives his paycheck every two weeks with gross pay of $4,500. He also receives $200 in interest and $600 in equity as his other forms of income.
He then pays all her taxes including:
- Social Security taxes ($279)
- Federal taxes ($450)
- State taxes ($163.91)
- Medicare taxes ($65.25)
- Insurance ($280)
Usually, these are automatically taken out of your paycheck. After all these deductions, Mike is left with a net income of $3,220.00 Here are the exact steps to calculate it.
Gross Income – Total Expenses = Net Income
For Mike, the math would look like this:
$4,500(GrossPay)+$200(Interest)+$600(Equity)–$280 (Social Security Tax) – $450 (Federal Tax) – $65 (Medicare Tax) – $165 (State Tax) – $320 (Insurance) = $4,020.00 (Net Income)
Understanding Net Income vs. Gross Income
It’s essential to distinguish between net income and gross income:
- Gross Income: This is the total revenue minus the cost of goods sold (COGS). It represents the profit a business makes before considering operating expenses and taxes.
- Net Income: As discussed earlier, this is the ultimate profit figure after all expenses, including operating expenses and taxes, have been subtracted. For a more comprehensive view of a company’s financial performance, both gross and net income should be analyzed.
The Importance of Accurate Net Income Calculation
Accurate net income calculation is vital for various reasons:
- Financial Decision-Making: Businesses use net income as a basis for financial decision-making, such as budgeting, investment, and expansion plans.
- Tax Planning: Proper reporting of net income is crucial for tax planning and compliance. Accurate figures ensure businesses meet their tax obligations while minimizing tax liabilities.
- Investor Confidence: When businesses consistently report healthy net income figures, it builds investor confidence, potentially attracting new investments.
- Lender Relations: Lenders often rely on net income to assess a company’s creditworthiness. Accurate reporting can help secure loans and better financing terms.
In Conclusion
Net income is a fundamental financial metric that provides insights into a company’s profitability and financial health. Understanding the net income formula and its significance is essential for accountants, business owners, and investors. Accurate calculation and reporting of net income can drive sound financial decisions and pave the way for a company’s success.
How Prolific Financial Can Help Properly Track your Net Income
Net income is a critical metric for any individual or business’s financial health. The monthly income statement report details how effective the sales and operations process is at achieving financial success.
At Prolific Financial, generating up-to-date net income reports is one of the many bookkeeping, accounting, and tax services you can access from our organization.
With Prolific Financial, you get a team of real people and bookkeepers who dedicate their skills and expertise to the success of your business or individual finances. Additionally, we integrate our services with the best software such as QuickBooks Online and XERO to ensure all your accounts are accurate. Get started today to meet your dedicated expert bookkeeper & Accounting Professional.
