In this article, you will learn:
Net Income is one of the critical components of your business’s three basic financial statements. Thus, tracking net income helps you to know the financial health of your business.
Net income indicates your business’s capacity to generate profits. Accordingly, increasing net income indicates efficiency, and decreasing net income may indicate increasing costs or falling revenues.
Furthermore, the creditors track the net income figure to ensure that you have enough money to pay your debts. Whereas, the investors would want to have an understanding of the amount of money left after paying dividends for the investment.
Thus, as a small business owner, it is important to track Net Income and understand its impact on the bottom line of your business.
In this article, you will learn what is net income, how to calculate Net Income and the effect of Net Income on your bottom line.
What is Net Income?
Net Income is nothing but the accounting profit that remains after deducting all the expenses from the business revenues. It is calculated by deducting the following expenses from the sales revenue:
- Cost of Goods Sold
- Selling, General, and Administration Expenses
- Depreciation and Amortization
- Interest Expense
- Any Other Expense
Thus, Net Income is a measure of the profitability of your business and is the last item on the Income Statement of your business.
So, your business’s Trading account showcases the outcome of its manufacturing activity. Accordingly, the items in your Trading Account includes Sales Revenue, Direct Expenses such as wages, Purchases, Opening Stock, and Closing Stock.
Thus, it calculates the Gross Profit which is nothing but the difference between your business’s Sales Revenue and Cost of Goods Sold (COGS). So, COGS is equal to Opening Stock, + Purchases + Direct Expenses – Closing Stock.
On the other hand, the Profit and Loss Account includes the carried down balance of Gross Profit on the credit side of the statement. Further, it includes expenses related to the business operations on its debit side.
These expenses include Selling, General, and Administrative Overheads, Interest Expense, Depreciation and Amortization, Taxes, and Other Expenses.
So let’s understand some of the basic terms associated with Net Income to have a clear understanding of its concept.
Direct Expenses are the expenses that can be directly attributed to a particular cost object. That is, these are the expenses that change with the change in the volume of the Cost Object.
The Cost Object is nothing but the items for which such expenses are measured. These items could be products, services, product lines, etc.
For instance, the cloth used is a direct cost if you manufacture garments. Similarly, the wages paid to the workers manufacturing the garments form a part of the direct expenses.
Thus, the following expenses are considered as your business’s direct expenses:
- Opening Stock
- Purchases (less) Purchase returns
- Wages paid to workers
- Carriage/Freight Inwards
- Packaging materials and packaging charges
Indirect expenses are the expenses that are incurred to run the business as a whole. That is, such expenses cannot be directly assigned to a specific Cost Object.
Some of the indirect expenses include:
- Selling expenses like the commission of the sales agent, salaries of sales personnel, traveling expenses, warranty costs, etc.
- Administrative overheads
- Factory overheads like the supervisor’s salary, factory rent, utilities, supplies, depreciation, etc.
- Interest expense
How To Calculate Net Income?
The Trading and P& L Statement, also known as the Income Statement, is one of the key financial statements used to calculate your business’s Net Income,
Net Income is also known as Net Profit or Net Earnings. So let’s understand how net income is calculated using the Net Income Formula.
Net Income Formula
As mentioned above, the Net Income is nothing but the amount of accounting profit that remains after your business pays off all its expenses.
Now, you first need to know what is Gross Income to understand the Net Income Formula. The Gross Income is nothing but the difference between Sales Revenue and Cost of Goods Sold. The following is the Gross Income Formula:
Gross Income = Sales Revenue – Cost of Goods Sold
Net Income = Gross Income + Other Incomes – Indirect Expenses or
Net Income = Revenue – Cost of Goods Sold + Other Incomes – Indirect Expenses
Let’s consider an example to understand how Net Income is calculated using the above Net Income Formula.
Net Income Calculation Example
Say, you want to find your business’s net income for April 2020.
|Cost of Goods Sold||$15,000|
Now, you first need to calculate Gross Income in order to calculate Net Income.
Gross Income = Total Revenue – Cost of Goods Sold
= $50,000 – $15,000
Now, calculate the total expenses to calculate Net Income. In this case,
Expenses = Utilities + Rent + Purchases + Payroll + Taxes
= $1,000 + $2,500 + $1,100 + $4,000 + $1,000
Net Income = Gross Income – Expenses
= $35,000 – $9,600
Where To Record Net Income
As mentioned above, the Net Income is the last item of your company’s Income Statement. The Income Statement is one of the three basic financial statements that represent the earning activities of your business.
It depicts the inflow of funds resulting from the sale of goods and services. Further, the Income Statement also depicts the outflow of funds in the form of resources used to generate such sales.
Accordingly, your business’s Income Statement represents its profitability. That is, profits earned or losses incurred during a specific period of time.
Through the Income Statement, you reach the Net Income of your business. Therefore, Sales, Cost of Goods Sold, Gross Income, Expenses, Interest, and Taxes are all items on an Income Statement. These items help in calculating your business’s Net Income.
As Net Income is the last item on the Income Statement, it is therefore called the ‘Bottom Line’.
The following is the Sample Income Statement to understand the line items as well as the representation of the Net Income or Loss on the Income Statement.
|Particulars||Amount in Dollars ($)|
|(-) Sales Discount||$1,000|
|Cost of Goods Sold (COGS)|
|Repair and Maintenance||$500|
Why is Net Income Important?
Net Income is one of the important indicators of the financial health of your business. As stated earlier, it represents the profit-generating capacity of your business.
Thus, you can understand the efficiency of your business operations by tracking its Net Income. In other words, you can track how much profits your business is able to generate given the current resources and the practices.
Accordingly, increasing Net Income gives you an understanding that you are efficient. However, falling Net Income indicates that you need to contain your operating and overhead costs.
It can be the case that company’s revenues are increasing but its operating costs are increasing at a rate higher than the increase in revenues.
Thus, your company’s Net Income as a percentage of sales will decrease. Therefore, falling Net Income as a percentage of Sales over the accounting periods can be carefully watched by the investors.
This is because they look for rising Net Income as a percentage of Sales. In addition to this, the investors keep a track of your business’s Net Income figure as they want to know the number of funds available after paying off the dividends. This is because such funds can be either be reinvested in the business or kept aside for unforeseen days.
Likewise, your business creditors track your business’s Net Income to understand whether the profits are sufficient to pay the outstanding debt.
What is Gross Income?
The Gross Income is the profit generated as a result of undertaking the basic operations of your business. It is an item that appears on the Trading and P&L Account of your business.
Furthermore, the Gross Income is calculated by deducting the sum of Purchases and Expenses from the Sales Revenue.
In other words, the Gross Income is nothing but the difference between Sales and Cost of Goods Sold.
The Cost of Goods Sold refers to the direct costs incurred to produce goods or render services with the purpose of sale. Such costs include the costs that can be directly attributed to a cost object. For instance, the cost of material, direct labor, etc.
Cost of Good Sold = Opening Stock + Purchases + Direct Expenses – Closing Stock
What is Operating Income?
The Operating Income is also referred to as the Operating Profit. It is the profit earned by undertaking normal business activities or operations.
In other words, the Operating Income is the excess of Operating Revenue over Operating Expenses. That is, the amount of profit earned from the normal business operations after deducting Operating Expenses like Cost of Goods Sold, Depreciation, Office Supplies, Utilities, etc.
Here, the Operating Expenses are nothing but the expenses incurred to conduct the normal business operations. These include expenses like rent, payroll, inventory cost, insurance, utilities, etc.
Thus, Operating Income helps to know how much income your business is able to generate from its core operations. That is, it does not include any expense or income not directly related to the core activities of your business.
Therefore, the investors are keen to see the Operating Income level of your business over different accounting periods. Increasing Operating Income is seen as a positive indicator for it tells that the management is generating more revenues from its core operations while containing operating and overhead costs.
Net Revenue Versus Gross Income
As stated above, gross income appears as an item in the trading and profit and loss account of your business. It is the income that your business generates after deducting costs directly associated with the production of goods or rendering of services.
Accordingly, Gross profit is calculated by deducing the Cost of Goods Sold from sales revenue.
Net profit, on the other hand, is the profit that your business generates after deducting all operating expenses, non-operating expenses, taxes, and the preferred stock dividend of the business from Gross profit.
Thus, Net profit is the measure of the profitability of your business and appears as the last item on your company’s income statement.
|Gross Income||Net Income|
|Difference between net sales revenue and cost of sales.||The profit that remains after deducting all operating expenses, non-operating expenses, taxes, and preferred stock dividends from the Gross Profit.|
|Gross Profit is an item in the Trading Account of a company.||Net profit showcased in the profit and loss account of a business.|
|Gross Profit demonstrates the efficiency of a business in making use of its labor, raw material, and other supplies.||Net Profit helps both the internal and external stakeholders in decision making from varied perspectives.|
|Gross Profit = Net Sales – Cost of Goods Sold||Net Profit = Gross Profit + Other Incomes – Indirect Expenses|