What is Net Income and Why is it Important?
Net income is a financial expression commonly used in reference to business finances and personal finances. It’s also easy to confuse with other measures of profitability such as gross profit, operating income, and earnings before interest and taxes (EBIT).
In this article, we will look at this critical financial term as it’s used for businesses and answer:
- What is net income?
- How do we calculate net income?
- Why is net income one of the most important, if not the most important, financial term for businesses?
What is net income and how do we find it?
Net income, sometimes referred to as net profit, is the bottom line result of a company’s income statement after accounting for operating expenses.
All revenues and expenses that arise in the normal course of business operations are recorded in the income statement, also referred to as the profit & loss (P&L) statement. Once all types of expenses are subtracted from revenues, a company will see its bottom line result, the net income. It’s the excess of revenues over total expenses and shows us the company’s profitability after accounting for all of its costs.
Here is an example with a company called Milky Way Inc.
We can see that the company is profitable because net income is positive. In addition, a financial analyst analyzing Milky Way Inc.’s P&L statement, will likely ask the question: “Why does the company’s net income change from $8,637 million to $8,381 million year over year?” And the answer to this question lies in understanding the changes to all the components that make up the income statement shown above.
How do we calculate net income?
As noted, the two primary drivers of net income are revenues and expenses.
Suppose you work as a financial analyst and you have been asked to analyze the income statement of Milky Way Inc., a dairy company that produces milk and cheese products that are sold to supermarket chains.
How would you approach this task?
First, you look into the company’s revenue. This is the amount reported from the sales of goods and services in the normal course of business operations. Gross revenue refers to the total dollars Milky Way receives from selling its products. As seen in the chart below, the current financial year gross revenue is equal to $53,488 million.
Once this amount is adjusted for estimated returns and allowances (AKA discounts), you’ll get net revenue. Some supermarkets may return products that are close to expiration, while others may be eligible to trade discounts. This is common practice across most consumer goods. Accounting for those losses is when the net revenue figure of $47,806 million comes from and how it differs from gross revenue.
Note that we can use the terms “revenue” and “sales” interchangeably. Although sales to customers are the primary revenue component, there may be other sources of revenue. Companies can generate funds outside their core operations, too.
For example, a company may rent some of its real estate or even benefit from the sales of manufacturing equipment. We would record any additional sources of revenue in the other revenue line. If Milky Way Inc. rents out one of its warehouses and receives $1,000 million in return, that payment is noted in other revenue since this activity is not part of the core business operations. This distinction allows us to separate core business sales from non-core activities.
The section shown in the chart above is the top line of the Milky Way Inc.’s income statement. That is, the sum of net revenue + other revenue = total revenue. This number decreased slightly from the previous financial year’s $50,041 million to $48,806 million in the latest accounting period.
You have to spend money to make money, which is why companies must also account for expenses that relate to their general course of business activities. To produce, deliver, and sell goods, companies must incur certain costs. The most common examples are the costs of goods sold, selling and marketing, general, administrative and interest expenses. Let’s look at what these types of expenses mean.
Cost of goods sold (COGS) are expenses incurred to produce the goods that a company sells. Milky Way Inc. buys raw milk from local producers, transports it, processes it, and then packages it before the milk is sold to supermarket chains. The company also incurs additional costs to produce cheese from the milk. Expenses that directly relate to the production of finished products are noted as the cost of goods sold. We see that Milky Way spends roughly $29,000 million each year on production.
Here comes the exciting part! The difference between the total revenue and COGS is called gross profit. This is the profit a company makes after deducting its costs of production. It serves as a first measure of profitability, showing whether the company is able to profit from the products it sells by taking into account only the cost to produce these products. Other expenses such as salaries of non-production personnel for example are not considered here. Negative numbers at this level should be alarming to a company’s finance team.
Below gross profit on the income statement we see operating expenses. These are the ongoing costs incurred for running the business. For example, every company generates some selling, general and administrative expenses (SG&A).
This category examines the costs of making sales, such as marketing and promotional expenses. It also includes office-related operating expenses, such as payroll costs. Office rent, utility bills for electricity, phones and water supply are other common examples of SG&A expenses. It seems that Milky Way’s annual operating expenses are stable – roughly $10,000 million per year.
When we deduct all distribution, sales & marketing and administrative expenses from the ‘gross profit’ figure, we get to ‘operating profit’. It is sometimes referred to as earnings before interest and taxes (EBIT).
Wait! Since we have earnings before interest and taxes, shouldn’t we have earnings after interest and taxes, too? Yes.
Most companies incur finance costs like interest and taxes, which they don’t consider when calculating their operating profits. For instance, interest expense is the cost that a company incurs for borrowing funds externally. Milky Way Inc. took a bank loan when it acquired a new milk processing system. The bank agreed to lend the necessary funds at an interest rate of 6%. That’s why every year, as seen in the graphic below, the company pays an interest expense on the total borrowed amount. As you can see, it is recorded on a separate line in the company’s income statement; $330 million in the previous financial year and $310 million in the current accounting year.
The next accounting equation to know is operating profit – finance costs = profit before tax (PBT).
Albert Einstein once said, “The hardest thing in the world to understand is the income tax.” He might be right. Every company pays a type of corporate income taxes that are proportional to the amount of their pre-tax profits. In the case of Milky Way, this amount is $960 million and $910 million in two consecutive years. Tax rules may vary depending on the country where the company operates and sometimes the relationship between profit before tax and income taxes is not linear.
Once all expenses are accounted for, we arrive at the bottom-line figure, net income.
Why is net income such an important financial indicator?
When a business has performed well and the net income total is positive, equity stakeholders can use the net income to calculate a ratio called return on equity (ROE). This number is calculated by dividing net income and the amount of equity capital invested in the business. ROE is a proxy for shareholders’ rate of return and serves as an indicator for potential investors whether a business satisfies their required rate of return.
The takeaway on net income’s importance for business? This is the amount a company — or, more specifically, its owners — earned at the end of a financial period.
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