A business’s income statement reports its earnings over a period of time, which can be a year, quarter, or month. The income statement paints a picture of what revenue your business takes in and what expenses you pay out over that time period.
Your costs, revenue, and expenses are directly related to how good your financial management is. You sometimes hear the concept of net income called “the bottom line.” That term is used to refer to net income because it is, indeed, the bottom line stated on the income statement of a business such as a sole proprietorship.
To help you gain a better understanding of this key financial figure, we’ll discuss what net income is, how to calculate it, and why it matters to your business.
- The income statement is a picture of the firm’s financial position over a period of time.
- To calculate net income, you have to develop an income statement to take account of all the firm’s revenues and expenses.
- Net income is a crucial financial metric for your firm in order for you to know how much money you made after accounting for all relevant expenses, and for you to be able to calculate key financial metrics such as net profit margin and earnings per share.
What Is Net Income?
Net income, also known as net profit or net earnings, is the amount of revenue a business has earned during a specific time period after all the expenses have been subtracted. To arrive at net income, you subtract the cost of goods sold (COGS) (if any), selling and administrative expenses, taxes, interest, depreciation, and amortization from the gross amount of revenue the business has generated. The figure you arrive at is the “net” of those expenses and is called the company’s net income.
Net income is what’s left over after all business expenses are paid. It is a number that is useful to the business owner for the purpose of analysis and study. The business owner uses the net income figure and the other line items on the income statement to know how well the firm has performed in meeting the standards it has set. Net income is one measure of the firm’s profitability.
How Do You Calculate Business Net Income?
In its simplest form, you calculate net income as:
Alternately, you can use this formula:
Normally, a small business such as a sole proprietorship uses a simple format for an income statement, which may also be referred to as a profit and loss statement. The term “income statement” is used in the financial statements that a business prepares at the end of an accounting period.
Here is an example of an income statement for a small business:
+ Non-operating Revenue
- Cost of Goods Sold (COGS)
= Gross Profit
- Selling and Administrative Expense
- Owner’s Draw
= Earnings Before Taxes
- Income Taxes
= Net Income
Interpretation of Line Items
- Operating Revenue: Sales receipts from business operations
- Non-operating Revenue: Money received from non-core business activities such as rent from a property
- Gains: Money received from non-core business operations outside the firm such as selling off equipment. Gains are often called “other income.”
- Cost of Goods Sold (COGS): The costs associated with producing and selling your product. You will not have COGS if you sell services instead of products.
- Gross Profit: Revenue from sales minus COGS
- Selling and Administrative Expenses: Non-product-related expenses such as rent, utilities, insurance, supplies, and marketing
- Interest: Interest paid on any loans you might have
- Owner’s Draw: The salary you take from your business
- Income Taxes: The amount of federal and state taxes you paid during the accounting period
Why Net Income Matters for Your Business
Net income is one of the most important financial metrics you can calculate for your business. It tells you how much money you have made and spent during that particular accounting period. It is also important if you have investors in your business because they can use net income to calculate your business’s earnings per share.
An income statement is an invaluable tool to calculate net income. It allows you to determine if your prices are too low, if your costs are too high, if your business is sustainable, or if it is taking losses.
The income statement and your net income also allow you to plan for the future. If you have the financial information over a period of time from the income statement, you are better able to take immediate corrective action if need be and create financial projections.
Net Income vs. Gross Income
Gross income is also called gross margin. It’s what you have left after you pay all the direct costs associated with the production of your product (if you sell products rather than services). Depending on the price of your product, you can grow your gross margin at a rapid rate. As your gross margin grows, you can make and sell more of your product. The same is true if you reduce your expenses of making that product, which is reflected in the cost of goods sold. Gross margin is an important financial metric for business owners to use if they want to expand their business.
Net income, on the other hand, is the actual amount of money you make in an accounting time period. As the gross margin grows, so may net income—although that is dependent on whether or not items like selling and administrative expenses increase.
The Bottom Line
Some small businesses try to operate without preparing a regular income statement. This is a bit like flying blind. It’s not enough just to take a look at your bank balance and expenses on your check register. To get an adequate picture of net income and make informed decisions for your business, you have to prepare an income statement so you can look at important financial metrics such as gross margin and net profit margin.
Frequently Asked Questions (FAQs)
How do you calculate the net income margin?
Net income margin, usually called net profit margin, is a measure of how much income is generated by a business per dollar of sales revenue. Here is the calculation:
Net Income margin = Net Income/Total Revenue
Net income margin is a comparison of total revenue received during a time period to the income you have left after all expenses are subtracted. You divide the bottom line number on the income statement by the top line number to get a percentage. For example, if you get 5%, that means you earn 5 cents for every dollar of sales after taking your expenses into account.
Which financial statements does net income appear on?
Net income appears as the bottom line figure in the income statement. It also appears in the statement of cash flows as the top line figure under operating activities and is recorded in the statement of retained earnings.
What is net operating income?
Net operating income is your income after your production costs and the costs of administrative expenses such as marketing are subtracted. It is the income you generate from your operating expenses. A synonym for net operating income is earnings before interest and taxes (EBIT).