Net income is the total amount of money your business earned in a period of time, minus all of its expenses, taxes and interest. It measures your company’s profitability. Next to revenue, it’s the most important number in accounting.
Also sometimes referred to as “net profit,” “net earnings,” or simply “profit,” net income is the opposite of a net loss, which is when your business loses money.
Ever heard someone say that a business was “in the red” or “in the black”? That’s because accountants used to literally record a net loss in red ink, and net income in black ink.
Why is it important?
Although many small businesses don’t start calculating their profitability until they’re forced to by a lender or investor, keeping track of your net income is one of the best ways to monitor the health of your business. If your net income is increasing, you’re probably on the right track. If it isn’t, it might be time to cut costs.
It’s also important to your lenders, who want to make sure that you have enough money to pay back all of your debts, and your investors, who want to know how much money the business will have left over to pay dividends, reinvest in the business, or set aside for a rainy day.
How do I calculate it?
If you know your total income and your total expenses, you can calculate your net income pretty easily: just subtract the second figure from the first.
If you’re like most businesses however, you’ll need to create an income statement, which is one of the three major financial statements. Also sometimes called a ‘profit and loss statement,’ the point of a company’s income statement is to show how you arrived at your net income.
An income statement does this by taking your total revenue for that period (this is usually the first line of the statement) and then subtracting each of your expenses and losses, line by line, until it spits out your net income on the very last line. This is also why you’ll sometimes hear people refer to net income as “the bottom line.”
Further reading: How to Calculate Net Income
Here’s an example income statement for Coffee Roaster Enterprises Inc., with net income listed at the very bottom:
Coffee Roaster Enterprises Inc.
For Year Ended Dec. 31, 2020
|Cost of Goods Sold (COGS)||$24,984.79|
|*Bank & ATM Fee Expenses||$9.43|
|*Merchant Fees Expenses||$794.19|
|Earnings Before Income Tax||$16,016.34|
|Income Tax Expense||$10,000.00|
Further reading: Understanding an Income Statement (Definition and Examples)
What is gross income?
It’s important not to mix up gross and net income. Also sometimes called gross earnings or gross profits, gross income is your revenues minus your cost of goods sold (COGS), which are the direct expenses involved in producing your products or services.
We can express this in equation form as:
Gross income = revenue – cost of goods sold (COGS)
You’ll usually find your business’ COGS listed near the top of your income statement, just under revenues.
Common examples of COGS include:
- Raw materials
- Packaging, freight and shipping
- Energy and utility expenses for a production facility
- Depreciation expenses on production equipment and machinery
Keep in mind that COGS doesn’t include indirect expenses (sometimes called ‘overhead’ ‘operating costs’ or ‘operating expenses’) like salaries for lawyers, accountants, and management, utilities, insurance, interest, etc.
What about operating income?
Operating income is another, more conservative measure of profitability that goes one step further than gross income. It includes operating expenses (sometimes also known as Selling, General, and Administrative [SG&A] expenses) which are any costs a company generates that don’t relate to production. Operating expenses don’t include non-operating expenses like interest, taxes, amortization and depreciation.
The equation for operating income is:
Gross income – operating expenses = operating income
Gross income, operating income and net income are the three most popular ways to measure the profitability of a company, and they’re all related too.
You can see how gross profit, operating income and net income are just different, increasingly conservative measures of profitability by writing out the formulas for all three:
Revenues - COGS = Gross profit
Revenues - COGS - Operating expenses = Operating income
Revenues - COGS - Operating expenses - Non-operating expenses = Net income
Notice how the equation for net income includes all three major expense types: COGS, operating and non-operating expenses? That’s because it’s the most conservative, most reliable measure of profitability we’ve got.