Net Income
Calculated as sales minus the cost of goods sold, interest, taxes, depreciation and amortization, and other expenses for a given accounting period
What Is Net Income?
In accounting, net income is calculated as sales minus the cost of goods sold, interest, taxes, depreciation and amortization, and other expenses for a given accounting period.
Due to its usual location on the last line of an organization's income statement, it is commonly termed the bottom line.
Three names are frequently used interchangeably to refer to the bottom line of an income statement for a business, including:
- Net income
- Net earnings
- Net Profit
For those unfamiliar with finance and accounting, the meaning of all three terms can be confusing, but they are the same. Net income can either be added to retained earnings by the company, given as a dividend to ordinary stockholders, or split between the two options.
Net earnings and net profit are frequently used as synonyms for net income because profit and earnings are often used interchangeably in the context of income.
It can also be referred to as the net growth in shareholders' equity due to a company's operations. It's distinct from the gross income, which is the result of subtracting the cost of products sold from the revenue obtained from the sales.
For families and individuals, the net income is defined as (gross) income less any applicable deductions and taxes—for example, mandatory pension contributions. Businesses determine their earnings per share using the net income attributable to common shareholders.
We can also calculate FCFE (Free cash flow to equity) from net income. After all debts are paid, a company's free cash flow to equity (FCFE) ratio shows how much money is left over for distribution to shareholders.
When a company has managed to increase its net income over time, investors may be more inclined to purchase its outstanding shares of stock, potentially influencing its stock price. Therefore, assuming all other factors are equal, a greater EPS often results in a high stock price.
Key Takeaways
- Net income in accounting is the result of subtracting various expenses, taxes, and costs from total sales. It is often termed the bottom line and is synonymous with net earnings and net profit.
- The calculation involves deducting tax expense, financing expense, minority interest, stock dividends, cost of goods sold, sales discounts, and returns from total revenue. The formula is
- NI = Pre-Tax income - Tax expense
- Net income and cash flow are distinct metrics. Net income reflects profitability, while cash flow considers actual cash movements. Cash flow provides insights into a company's ability to generate and manage cash for day-to-day operations.
- Net Income After Tax (NIAT) is the profit remaining after deducting all necessary taxes. It is a crucial figure for assessing a company's financial health and profitability.
- Net income, gross profit, and operating profit are key profitability indicators. Gross profit focuses on production costs while operating profit assesses core operational efficiency. Net income provides an overview of a company's profitability and is crucial for investors.
Calculation of Net income
Typically, net income (NI) is calculated annually for each fiscal year by starting with the organization's total revenue and subtracting various expenses, taxes, and other costs.
From the total revenue, we then deduct the following:
- Tax expense: Any sum a person or company owes to the government in taxes is considered a tax expense.
- Financing expense: The cost, interest, and other fees associated with borrowing money to construct or purchase assets are referred to as financing costs, sometimes known as the cost of finances.
- Minority interest: The percentage of a subsidiary corporation's equity that the parent company does not own is known as the minority interest.
- Stock dividends: A common stock dividend is a payment made from the company's profits to holders of its common stock.
- Cost of goods sold: When a company sells some of its products, the direct costs related to producing these products are known as the COGS.
- Sales discounts: A sales discount is a price decrease the seller offers in exchange for the buyer paying the vendor in full and on time.
- Sales returns: A sales return is something the buyer sends back to the vendor for a full refund.
Other elements may include Allowances, Cost of manufacturing, and Cost of advertising/design/development.
It can also be calculated using the following formula:
NI = Pretax income - Tax expense
The NI a business earns before taxes are deducted or taken into account is referred to as pretax income, earnings before taxes, or pretax earnings, but net income is the profit after deducting all expenses, including taxes.
Note
Operating and non-operating income can be combined to calculate the net income by deducting taxes.
Like other accounting measurements, it can be manipulated using techniques like expenditure concealment. Therefore, investors should examine the accuracy of the methods used to calculate the taxable income and NI before deciding to invest.
Net income Vs. Cash flow
The company's economic profit or cash flow is not reflected in its net income, as it consists of several non-cash costs, including stock-based compensation, depreciation, and amortization.
Thus, the quantity of cash flow a corporation produces during the pertinent time does not equal its net income.
A cash flow (CF) chart displays the inflows (payments) and outflows (receipts) of cash during a specific time period. It shows the sources and applications of cash during a particular period.
Additionally, it analyzes the reasons for changes in the balance of cash between the beginning and end of a specific period. Financial analysts take significant measures to adjust for non-cash items following accounting principles to arrive at cash flow for evaluating a company.
NI determines earnings per share and profits, whereas cash flow assesses the financial position, solvency, working capital, and management proficiency.
Net profits are subject to different management considerations compared to cash flows.
Let's take a look at the table below to understand the difference clearly:
| Metric | Net income | Cash flow |
|---|---|---|
| Definition | Net income, or profit, is the difference between a company's total revenue and expenses during a specific period. | Cash Flow is the amount of cash and cash equivalents generated or used by a period, including operating, investing, and financing activities. |
| Purpose | Net income provides an overview of a company's profitability and is a key metric for assessing income tax obligations and shareholder dividends. | Cash Flow provides insights into a company's ability to generate and manage cash, which is essential for day-to-day operations and long-term sustainability. |
| Timing | Calculated based on accrual accounting principles and includes non-cash items. | Calculated based on the cash accounting method, which focuses on actual cash flows. |
| Volatility | Susceptible to fluctuations due to accounting adjustments, such as depreciation and amortization. | More stable and less prone to accounting adjustments and non-cash items. |
| Key Metrics Derived from the Metric | Earnings per share (EPS), Price-to-Earnings (P/E) ratio, Return on Equity (ROE). | Free Cash Flow (FCF), Operating Cash Flow (OCF), Cash Flow from Investing (CFI), and Cash Flow from Financing (CFF). |
| Importance for Investors | Provides insight into a company's profitability and earnings potential. | Offers a more comprehensive view of a company's financial health, including liquidity and cash management. |
Net income after Tax
Net Income After Tax (NIAT) is an accounting term that describes a company's profitability after deducting all necessary taxes. It is the profit of a business after deducting all taxes, expenses, and other liabilities.
Net income is considered the company's bottom line, as found at the bottom of the income statement. Therefore, it is one of the most important figures to analyze once looking into a company's financial statements.
After-tax income can be referred to as a business's net income, which is the profit after deducting all necessary taxes, expenses, and other liabilities. These taxes include federal, provincial, withholding, state, and local taxes such as sales and property taxes.
Individual taxpayers in the US file Form 1040 with the IRS to record their yearly income. There isn't a line for NI on this form. Instead, it provides spaces for taxable income, adjusted gross income (AGI), and gross income to be entered.
Taxpayers deduct some income sources like Social Security benefits and permissible deductions like student loan interest after calculating their gross income. Therefore, their AGI makes a difference.
Although occasionally used interchangeably, NI and AGI are two distinct concepts in calculating an individual's taxable income. The taxpayer calculates their taxable income by deducting standard or itemized deductions from their AGI.
Note
As previously indicated, the individual's net income accounts for the difference between taxable income and income tax; however, this amount is not noted on individual tax returns.
Net income Vs. Gross profit
Gross and Net income are every business's two most important profitability indicators. Gross profit can be regarded as the profit still available after production costs are removed from sales.
Gross profit is commonly referred to as gross income. On the other hand, NI is the amount of profit left over after all expenditures and expenses have been reduced from the revenue.
As stated earlier, investors can use the net profit to evaluate a company's performance by assessing overall profitability.
Gross profit is calculated by deducting the cost of goods sold, sometimes mentioned as COGS, from the sales.
The cost of goods sold (COGS) is an expense account listed in the income statement of merchandising companies. It includes everything a business pays to produce the goods sold in a specific period.
It involves all the direct costs the business incurs to produce the goods it sells. These costs include the raw materials and labor used in the production process, but they can also include other specific overhead costs.
NI can be calculated by deducting operating expenses, other expenses, taxes, and interest on the debt from the gross profit.
Let's understand the basic difference in the table below:
| Aspect | Net Income | Gross Profit |
|---|---|---|
| Definition | Net income, or profit, is the difference between a company's total revenue and expenses during a specific period. | Gross Profit is the revenue generated from sales minus the cost of goods sold (COGS) directly associated with producing goods or services. |
| Purpose | Net income provides an overview of a company's profitability and is a key metric for assessing income tax obligations and shareholder dividends. | Gross Profit focuses solely on a company's ability to generate profit from its core operations, excluding operating expenses. |
| Timing | Calculated based on accrual accounting principles and includes non-cash items. | Calculated based on revenue recognition and COGS. |
| Volatility | Susceptible to fluctuations due to accounting adjustments, such as depreciation and amortization. | Less susceptible to accounting adjustments and non-operating factors but subject to fluctuations in COGS |
| Key Metrics Derived from the Metric | Earnings per share (EPS), Price-to-Earnings (P/E) ratio, Return on Equity (ROE). | Gross Profit Margin (GPM), Gross Margin, Operating Income, and Operating Margin. |
| Importance for Investors | Provides insight into a company's profitability and earnings potential. | Indicates a company's ability to generate profit from its core operations, serving as a basis for further analysis. |
Net income Vs. Operating profit
Both profit indicators determine a company's profitability, although they differ significantly.
Operating profit, or income, is the amount left over after operating costs are deducted from gross profit. All operating expenses, including those considered in the gross profit calculation, are included in the operating profit, which extends the profitability statistic.
After all costs have been deducted, operating profit displays a company's earnings, excluding the cost of debt, taxes, and some one-time expenses. It is also referred to as earnings before interest and taxes (EBIT). An organization's earning potential in relation to revenues from continuing activities is represented by operating profit.
Similarly, net income (NI) is the profit left over after all expenses during a specific period have been deducted from sales revenue.
Let's understand the difference below:
| Aspect | Net income | Operating profit |
|---|---|---|
| Definition | Net income, or profit, is the difference between a company's total revenue and expenses during a specific period. | Operating profit, often called Operating Income or Earnings Before Interest and Taxes (EBIT), measures the profit generated from a company's core operations before interest and income taxes are deducted. |
| Purpose | Net income provides an overview of a company's profitability and is a key metric for assessing income tax obligations and shareholder dividends. | Operating profit assesses a company's profitability from its primary operations, excluding financing and tax factors, providing insights into operational efficiency. |
| Timing | Calculated based on accrual accounting principles and includes non-cash items. | Calculated before deducting interest and income taxes, using accrual accounting principles. |
| Volatility | Susceptible to fluctuations due to accounting adjustments, such as depreciation and amortization. | Less susceptible to accounting adjustments and non-operating factors but subject to changes in operating performance. |
| Key Metrics Derived from the Metric | Earnings per share (EPS), Price-to-Earnings (P/E) ratio, Return on Equity (ROE). | Operating Margin, Earnings Before Interest and Taxes (EBIT), EBIT Margin |
| Importance for Investors | Provides insight into a company's profitability and earnings potential. | Measures the core profitability of a company's operations, helping investors assess the effectiveness of its primary business activities. |
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