Net income is the key metric used to determine an organization’s financial health. Many consider this number the most significant of all financial indicators because it determines whether your company has made a profit.
Fortunately, you don’t have to be a CPA to master the basics of net income.
In this article, you will begin to understand the scope of net income, the calculations involved, and what it can tell you about your business’s bottom line.
Understanding Net Income
Net Income (NI), also called net earnings or net profit, is the total amount earned in a period minus expenses. Examples of the type of expenses include:
- Advertising and Marketing
All revenues and expenses are recorded at the top of the income statement, also called the Profit and Loss or P&L. Once all expenses have been subtracted from revenues, a company will see their profit remaining, the net income.
NI is also used to calculate an organization’s profit margin. This metric is net income expressed as a percentage of revenue. Following this percentage month after month is a good way to track whether a business is becoming more or less profitable over time.
If your net earnings increase over each period, you are likely on the right track. However, if your NI is going down month after month, it might indicate you need to start cutting costs.
Gross vs Net
The key to simplifying NI is by comparing and contrasting gross versus net. Whether you are looking at revenue or income, the gross number is always larger than the net.
Gross profit signifies the total amount of money a company makes minus the cost of goods sold. COGS are expenses incurred to produce the goods that a company sells. These expenses include raw materials, labor, packaging, and utilities in a manufacturing facility.
Gross profit does not include other costs associated with marketing or selling activities, administration, taxes, etc.
Gross revenue is the aggregate sale price of goods and services over a period of time. Gross revenue is also known as total revenue or the top line, as this is the starting point from which other financial metrics are calculated in a P&L.
Lastly, net revenue is how much gross revenue remains after deducting commissions, sales, losses, or returns. Knowing your net revenue can help you understand what discounts work in your business, for example.
The last of the three standard income calculations is operating income. Operating income is a more conservative approach than gross income as it also subtracts operating expenses. Like GI and NI, operating income is another way to view profitability and success.
All three forms of income are crucial when applying for financing. Banks and lenders typically look at your business’s income with and without expenses to predict a company’s future performance before approving a loan.
Sometimes it is easier to differentiate between these terms by looking at the equations.
You may need to do additional calculations to find your business’s total revenue.
These equations give a different perspective of the business’s finances and differ depending on which analysis you are running.
Revenue alone will not give you a comprehensive representation of your finances. It would be best to incorporate NI to fully understand your organization’s profitability.
NI and GI reveal a different perspective and thus can affect actions you might take as a business owner. Gross income can indicate the revenue generated year over year and give a perspective on how your business is doing. However, net income will tell you a slightly different picture of how much you are making after expenses are factored into the equation.
Even though net income is a critical metric within all three financial statements, it is not an indicator of cash flow. NI includes non-cash items like depreciation and amortization. Therefore, creating a separate process for your cash flow management is highly recommended.
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