Net income is revenue minus expenses, interest, and taxes. Here’s what you need to know about net income and why businesses and individuals pay close attention to it.
Business
In a business context, net income is revenue minus expenses, interest, and taxes. Net income is the same as the “profit” of a business, or its “earnings.” Of course, a business may not bring in enough income to cover its expenses. If expenses and other reductions are greater than the income of the business, the business has a net loss. In general, when a company’s net income is low or negative, a myriad of problems could be to blame, ranging from decreasing sales to poor customer experience to inadequate expense management.
There are a few reasons why businesses calculate their net income.
Earnings per share
Businesses use net income to calculate their earnings per share. Earnings per share is the part of a company’s profit devoted to each share of a common stock. This is one indicator of a company’s profitability. This is determined by taking the net income minus the dividends on preferred stock and dividing that number by the average outstanding shares.
Profitability
Net income is also used to determine a company’s profitability over time. By measuring this number quarterly, yearly, and year after year, investors, executives, and stakeholders can determine how quickly a company is growing, whether or not a company is profitable, and then use those numbers to make projections for future revenues and goals.
Investors and Creditors
Investors, creditors, and management tend to focus on net income because it’s a good indicator of a company’s financial position and ability to manage assets efficiently.
Investors want to know that their investment will continue to appreciate and that the company will have enough cash to pay them a dividend. Creditors want to know that the company is financially sound and able to pay off its debt with successful operations. Meanwhile, company management is typically concerned with both investor and credit concerns along with the company’s ability to pay salaries and bonuses.
In short, net income is the perfect calculation to determine a company’s bottom line, make estimations, and make projections for the future.
Individual
For a wage earner, net income is simply your take-home pay after deducting all taxes, benefit payments, insurance, and any other miscellaneous deductions. Keeping track of your net pay requires that you keep tabs on your total income from income statements and track any and all tax deductions.
Net and gross income are similar concepts but individuals should be able to differentiate between the two. Mixing up gross income and net income can have financial consequences, like incorrect tax returns resulting in potential penalties.
Depending on the severity of any penalties, miscalculating your net income could ultimately hinder any budget plans, whether that’s putting down a deposit for a house or saving for a lavish retirement. The importance of planning ahead and getting the math right cannot be overstated.
How to calculate net income
Business
Gross business income already deducts the cost of goods sold. To calculate net income, other expenses—including taxes—have to be deducted as well. Thus, the formula for calculating it is:
Total revenue minus total expenses = net income.
Let’s take a look at an example of a net income calculation for a business.
Kyle owns a server technology company that he runs out of his house. He manages data, security, and servers for different finance companies that need to adhere to compliance regulations (in a European context, think GDPR).
Kyle is able to make large amounts of revenue while keeping his expenses low. Here is a list of his income statement items for the year:
Revenues: 200,000
Computer expenses: 10,000
Salaries: 50,000
Utilities: 5,000
Taxes: 2,500
Kyle can calculate his annual net income by subtracting total expenses (67,500) from total income: 200,000 minus 67,500 = 132,500.
Since Kyle’s revenues exceed his expenses, he will show 132,500 profit. However, if Kyle only made 50,000 of revenues for the year, he would not have negative earnings. Instead, he would have a net loss of 17,500. The net income definition goes against the concept of negative profits. If the company loses money, it is classified as a loss. If the company makes money, it is considered income or profits.
Net income, in deducting other expenses, involves more than just the most direct expenses related to the product sold. Selling expenses, aka expenses required for the labor in selling your product, are taken into account. That includes salaries and benefits for employees at the business.
Travel expenses are deducted from revenue, as are expenses related to the company’s office. Money spent on advertising, marketing, events, and client-related expenses is also deducted.
With all the expenses taken out, ideally you can get a better idea of how profitable your business is, and if the money you make selling your product is more than the money you spend on the business.
Individual
Individuals don’t have quite the same expenses required for deduction that businesses do, but for a single person’s net income, for example, there is still plenty to deduct.
Calculating your net income involves looking through some records and doing a bit of math, but it’s straightforward once you know the process.
1. Calculate your gross annual income
Your first step to calculating your net income is finding out your gross income. Gross income is the total amount of money you make in a year before taking taxes or deductions into account. It’s your starting point for calculating net income. If you are on a salary or work stable hours, this should be fairly easy to calculate.
Take a pay slip from one of your pay periods. If your employer takes out taxes, look at the total amount before deductions. This is your gross pay for the period.
Figure out how often you are paid, and multiply the gross pay accordingly. If you’re paid monthly, multiply the number from your pay stub by 12 to get your gross annual income. If you’re paid weekly, multiply it by 52. If bi-weekly, multiply by 26.
If you work irregular hours, you’ll have to add up all your pay stubs for the year to get an accurate measure of your annual income.
If you work multiple jobs, take all of them into account in this calculation.
In most cases, gifts and inheritance do not factor into gross income. These are still taxable, however, so remember to account for them when filing your taxes.
2. Subtract any deductions
Since net income refers only to your income after taxes, you have to subtract any deductions you have from your gross annual income. After you subtract any deductions from your gross income, then you’ll end up with your total taxable income.
For example, if you had a gross income of $50,000 and $5,000 in deductions, then your taxable income is $45,000.
3. Deduct your retirement contributions if applicable
Under certain circumstances, your individual retirement arrangement (IRA) can be deducted from your taxable income. If you’re allowed to deduct $2,000 from your taxable income, your taxable income falls from $45,000 to $43,000.
4. Deduct your medical and dental expenses if applicable
As with retirement savings, you can sometimes deduct medical and dental expenses from your taxable income. This varies depending on your particular situation.
5. Subtract what you owe in taxes from your annual pay
After you’ve found out what your total taxable income is, then subtract the amount you owe in taxes. Subtract the total taxes from your income to get your net annual income.
Net income vs gross income
Net and gross income are similar concepts but businesses and individuals should be able to differentiate between the two.
If your gross income is still a profit after everything that has to be deducted is deducted, that’s net income.
Things you need to know about net income
Finally, a couple of commonly asked questions and misconceptions about net income.
If a company has high net income does it have high cash flow too?
Not necessarily. It’s important to know that net income is not a measure of how much cash a company earned during a given period. This is because the income statement includes a lot of non-cash expenses such as depreciation and amortization that aren’t the same as cash expenses.
To learn about how much cash a company generates, you need to examine the cash flow statement.
What’s the best way to compare net income between companies?
Net income varies greatly from company to company and from industry to industry. Because net income is measured in monetary amounts and companies vary in size, it’s often more appropriate to consider net income as a percentage of sales, known as “profit margin.”
Investors like to compare company earnings using the price-to-earnings (P/E) ratio, which says how much they are paying (the stock’s price) for each monetary unit of net income that the company is able to generate.
