Net income or net earnings is a useful metric for both business owners and investors that allow them to gauge the revenue generated from any venture. Furthermore, it aids business-owners to account for their venture’s profitability in a given period and enables investors to assess the ratio of revenue and expenses of a company much better.
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What is Net Income?
Net income of an entity popularly indicates the net profit or net earnings. Typically, net earning denotes the sum of money an individual or entity accrues after taxes, and other forms of deductions are subtracted from the gross income.
It must be noted that the net income meaning for business tends to be more encompassing when compared to the individual net income. To elaborate, for business entities, net income tends to indicate the efficiency of a firm in managing their earnings and expenses. On the other hand, for individuals, net income may simply refer to their gross income minus expenses or the amount they take home.
In simple words, it is the amount left to pay company shareholders, pay off existing debts, invest in new projects, purchase new equipment or save for the future.
Types of Net Income
In a broader sense, net income is of two types, namely –
- Net income for business
In case of businesses, net earnings are also termed as “bottom line” owing to their positioning at the bottom of the company’s income statement. Companies which are traded publicly rely on net income to compute their earnings per share accurately.
Ideally, the net income of a firm is reported on the company’s income statement and is examined extensively by shareholders, potential investors and lending institutions. It indicates a company’s solvency and its ability to shoulder additional financial obligations. Notably, negative or low net income may lead to a substantial drop in the valuation of a company’s shares.
Here is a list of things that are subtracted from the total revenue of a company to ascertain its net earnings –
- Cost of goods sold
- Operating expenses
- Dividends on preferred stocks
- Net income for individuals
In case of individuals, net income equals earnings accrued in a given period minus a few specific expenses and financial obligations. In other words, the difference between one’s taxable income and income tax, among other obligations is their net income.
Usually, these following are subtracted to find out one’s net earnings –
- Insurance policies
- Child support
- Loan payment
- Legal obligations
- Contribution towards a retirement account
Net Income Calculation Example
One can easily calculate the net income of a company if they have information about these following items –
- Total revenue
- Cost of goods sold
- Total expenses
Subsequently, one must be familiar with these basic formulas to compute the same easily.
Net income = Revenue – Cost of goods sold – Expenses
Net income = Gross income – Expenses
Net income = Total Revenue – Total Expenses
Net income example: This table is an excerpt of the income statement of ABCL as in the first quarter of 2018. Using the information given in this table below, calculate the net income of the company.
|Cost of Goods Sold||20000|
As per the given information,
Net income = Gross Income – Expenses
= Rs. (40000 – 20000)
A positive net income indicates that a company has good standing in terms of its profitability. It signifies that a company is liquid and is capable enough to pay off its financial liabilities and operating expenses, among others.
Once individuals ascertain the net income of a firm, they can proceed to find out about its operating income or earnings before income tax as well.
Typically, it is expressed as –
Operating net income = Net income + Interest expense + Taxes
Operating income = Gross profit – Operating expenses – Depreciation – Amortisation
Significance of Net Income
These following pointers highlight the significance of net income.
- It helps business owners and external analysts to assess if the company is making enough money or not. It also allows them to assess the proficiency and sustainability of the firm in terms of profit.
- Net income further helps the management of companies and lending institutions to estimate if they will be able to pay off their existing financial burden or not.
- A firm with high net income indicates financial viability and projects a positive image in terms of paying dividends to shareholders and expanding the scope of operations.
Nonetheless, there are a few limitations of using the net income of a firm as a potent financial metric. To elaborate, net income can be manipulated easily, and it often fails to project a company’s financial status accurately.
For instance, a company may be struggling to keep its everyday operations running. Still, it may project a healthy net income in the financial statements if it had sold high-value machinery recently. This is why many investors and financial analysts prefer operating net income over net earnings as a metric to gain a better idea about a company’s actual profitability.
Net Income versus Gross Income
Gross income plays a vital role in determining a company’s net income. However, it is crucial that one is familiar with the differences between the two concepts to gain a better idea about their role and significance in financial statements.
Typically, gross income defines the total earnings of a business entity before expenses like taxes and deductions are accounted for. On the other hand, net income is the earnings one generates after expenses like taxes and deductions have been subtracted from total income.
Net income of a firm helps to project a robust financial image and enhances its market valuation significantly. This is why business entities must make it a point to devise measures to increase their net income and also look for ways to boost their operating income sustainably.