Net income, also called net profit, is a calculation that measures the amount of total revenues that exceed total expenses. It other words, it shows how much revenues are left over after all expenses have been paid. This is the amount of money that the company can save for a rainy day, use to pay off debt, invest in new projects, or distribute to shareholders. Many people refer to this measurement as the bottom line because it generally appears at the bottom of the income statement.
Investors, creditors, and company management tend to focus on the net income calculation because it is a good indicator of the company’s financial position and ability to manage assets efficiently. Investors what 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 the company if financially sound and able to pay off its debt with successful operations. Company management is typically concerned with both investor and credit concerns along with the company’s ability to pay salaries and bonuses.
So we’ve established that is an important measurement, but what is net income?
The net income formula is calculated by subtracting total expenses from total revenues. Many different textbooks break the expenses down into subcategories like cost of goods sold, operating expenses, interest, and taxes, but it doesn’t matter. All revenues and all expenses are used in this formula.
As you can see, the net income equation is quite simple. It measures excess revenues over total expenses. This way investors, creditors, and management can see how efficient the company was a producing profit.
You can look that the net profit formula a step further by looking at the income statement. For instance, if you don’t what the total revenues of the company are, here is how to calculate net income using the gross profit instead of total revenues.
Since gross profit is simply total revenues less cost of goods sold, you can substitute it for revenues. Just remember not to subtract the cost of goods sold twice. This is a pretty easy equation, so you don’t really need a net income calculator to figure it out.
Let’s take a look at the simple equation for this net income example. Aaron owns a database and server technology company that he runs out of his house. He manages data, security, and servers for many different medical companies that require strict compliance with federal rules. As such, Aaron 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
Aaron would compute his annual net income by subtracting total expenses ($67,500) from total income.
Since Aaron’s revenues exceed his expenses, he will show $132,500 profit. If Aaron only made $50,000 of revenues for the year, he would not have negative earnings, however. 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 profits is one of the most basic measurements in accounting and finance. Obviously, higher profits are almost always preferable to lower profits. Businesses can use higher profits to reinvest in new equipment, eliminate debt, and even make payments to shareholders, but higher profits aren’t always favorable.
Since corporations pay taxes on their profits, it would make sense that management would try to minimize profits on a tax basis to reduce the taxable income. This is why many companies have a book to tax adjustment at the end of each year. They have to adjust their book income to reflect certain tax options that are being taken advantage of. For instance, some companies might use LIFO for tax purposes and FIFO for book purposes in order to reduce the income shown on the tax return. Accelerated depreciation is also used for the same reason.
Conversely, many companies are required to meet certain profits each year in order to maintain loan covenants with their lenders. These covenants present a problem. On one hand, management wants to show less profit to reduce taxes. On the other hand, they need to show more profit to meet lender’s requirements. This is where earnings and net profit can get manipulated. Certain revenue recognition rules can be applied loosely in order to meet management’s expectations. That is why it’s important to read the financial statement footnotes and understand what measurements were used and how to find net income in the financial statements.