Also referred to as “net profit,” “net earnings,” or simply “profit,” a company’s net income measures the company’s profitability. Net income is the opposite of a net loss, which is when a business loses money. Next to revenue, net income is the most important number in accounting.
Ever heard someone say that a business was “in the red” or “in the black”? That’s because accountants used to record a net loss in red ink, and net income in black ink.
Why is net income 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 financial 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 an important metric for your lenders and investors. Lenders want to make sure you have enough money to pay back all of your debts. Investors want to know how much money the business will have leftover to pay dividends, reinvest in the business, or set aside for a rainy day.
How to calculate net income
If you know your total income and your total expenses, you can calculate your net income:
Net income = total income - total expenses
In calculating your net income, most business owners need to create an income statement, which is one of the three main financial statements. Also called a ‘profit and loss statement,’ or ‘p&l,’ 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 item by line item, until it spits out your net income on the very last line. This is why you’ll sometimes hear people refer to net income as “the bottom line.”
- How to Calculate Net Income
- Profit and Loss Statements 101 (with Template)
- Income Statement Generator (Excel)
Example of 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, 2021
Further reading: Understanding an Income Statement (Definition and Examples)
What is gross income?
It’s important not to mix up gross income and net income. Also 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.
In equation form, this is:
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 (also called ‘overhead’ ‘operating costs’ or ‘operating expenses’). These operating expenses include things like salaries for lawyers, accountants, management, administrative expenses, utilities, insurance, and interest.
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 (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 costs like interest expenses, taxes, amortization, and depreciation.
The equation for operating income is:
Operating income = Gross income – Operating expenses
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.
By writing out all three formulas you can see how gross profit, operating income, and net income are different but increasingly conservative measures of profitability over a given accounting period:
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.
Additional small business resources
- How Much Are Taxes for a Small Business?
- Cash Flow Statements 101: Explanation and Example
- Do I Need a Business Bank Account?
- 10 Steps to Streamline Your Month End Close Process