Net income is defined as company revenue less expenses, and net income is reported in the income statement. Business owners may use the term earnings or profit when referring to net income.
Income statement formula
An income statement is created using the income statement formula:
Revenue less expenses = net income
Most companies produce a multi-step income statement, and this more detailed format documents how a firm produces net income.
Multi-step Income Statement
Assume, for example, that you’re a bicycle manufacturer, and that you’re creating a multi-step income statement for March. Most of your business activity will flow through gross profit:
$1,000,000 sales – $800,000 cost of goods sold = $200,000 gross profit
The materials, labor and overhead costs you incur to make bicycles are posted to cost of goods sold. In March, you sold $1,000,000 in bicycles, and the units you sold had a total cost of $800,000.
You incurred other expenses to operate your business in March, such as advertising costs, commissions paid to salespeople, and the cost to operate your home office. Operating expenses are subtracted from gross profit to calculate operating income:
$200,000 gross profit – $150,000 operating expenses = $50,000 operating income
Operating Income vs. Non-Operating Income
Operating income is generated from the day-to-day activities of running your business. In March, bicycle sales produced $50,000 of operating income. Your company also earned non-operating income, including $3,000 in interest income and a $1,500 gain from the sale of a machine.
$50,000 operating income + $4,500 non-operating income = $54,500 net income
Your business must be able to produce the vast majority of net income from operating income activities, because operating income is sustainable. Non-operating income is not consistent or predictable, and no company can survive over the long-term by relying on non-operating income to produce annual profits.
Connection to Balance Sheet
Net income increases the stockholder’s equity balance in the balance sheet, and this transaction is posted when the accounting books are closed at the end of each month and year. When the books are closed, each revenue and expense is adjusted to zero, and net income, which is the ending balance in the income statement, is posted as an increase in equity on the balance sheet.
Your bicycle manufacturer firm has a net income balance of $54,500 at the end of March. Assume, for example, that the stockholder’s equity section of the balance sheet has these balances before the books are closed in March:
|Additional paid in capital||$2,300,000|
Retained earnings is the total net income earned by your company since inception, less all cash dividends paid to shareholders since inception. A dividend is a payout of company profit. The $54,500 net income balance for March is added to the $3,100,000 balance in retained earnings.
Earnings per share
Net income is used to calculate earnings per share (EPS), which is a frequently used ratio to assess the value of a company’s common stock. Basic EPS is calculated as:
(Net income available to common shareholders) / (weighted average common stock shares outstanding)
If a company issues preferred stock, the firm is obligated to pay preferred stock dividends before using net income to pay a dividend to common stockholders. Weighted average common stock shares outstanding refers to:
[(Shares held at the beginning of the period) + (Shares held at the end of the period)] / 2
If your firm produces $4,500,000 in annual net income available to common shareholders, and your have 3,000,000 weighted average common stock shares outstanding, your basic EPS is $1.50 per share.
When a business can increase the earnings per share, the common stock is considered more attractive, and investors may drive up the price of the stock.