Net Income Formula – What is Net Income?

What Is the Net Income Formula?

Net Income Formula: Net income (NI) equals revenues minus expenses, interest, and taxes. It shows how much is left after all expenses are paid.

Net income (NI), is also called net earnings.  It is calculated by taking total sales and subtracting the expenses necessary to generate sales.  For example, the cost of goods sold, selling, general and administrative expenses, operating expenses, depreciation, interest, taxes, and other expenses. Investors use net income to determine if and how much the revenue exceeds the expenses of an organization. The number is listed on a company’s income statement and is also an indicator of a company’s profitability.

Net income is also referred to as net profit.  Again, the objective is to verify that total revenues exceed total expenses. It other words, it shows how much profit is left over after all expenses have been paid. This is the amount of money that the company can save for a rainy day, use to pay off debt, invest in new projects, or distribute to shareholders. Many people refer to this measurement as the bottom line because it generally appears at the bottom of the income statement.

Investors, creditors, and company management pay close attention to the net income calculation.  It is a good indicator of the company’s financial position and ability to manage assets efficiently.

• Investors want to know that their investment will continue to appreciate.  They want tangible evidence the company will have enough cash to pay them a dividend.
• Creditors want to know the company is financially sound and able to pay off its debt with successful operations.
• Company management is concerned with both investor and credit interests.  They also want to ensure the company is able to pay salaries and bonuses over the long term.

Net Income Formula – How to Calculate

Net income is a company’s total profits after deducting all business expenses. Some people refer to net income as net earnings, net profit, or the bottom line. It’s the amount of money remaining to pay shareholders, invest in new projects or equipment, pay off debts, or save for future use.  The net income formula is calculated by subtracting total expenses from total revenues. Different textbooks break the expenses down into subcategories.  This includes the cost of goods sold, operating expenses, interest, and taxes. Don’t be confused.  All revenues and all expenses should be used to properly calculate Net Income.  The Net Income Formula is:

Net Income = Revenue – (Cost of Goods Sold + Expenses)

Net income can be positive or negative. When a company has more revenues than expenses, there is a positive net income. However, if total expenses are more than total revenues, the result is negative net income.  This is also referred to as a net loss.  Using the formula above, you can find a company’s net income for any given period.  You can calculate annual, quarterly, or monthly—whichever time frameworks you wish to inspect.

Net Income Formula – Example

Let’s say ABC Company wants to find its net income for the first quarter of 2020. Here are the revenues and expenses:

• Total revenues: $75,000
• Cost of goods sold (COGS): $25,000
• Rent: $5,000
• Utilities: $2,000
• Payroll: $15,000
• Advertising: $1,000
• Interest expense: $1,000

1. First, ABC calculates gross income by subtracting COGS from total revenues.  Gross income = $75,000 – $25,000 = $50,000
2. Next, ABC adds the total expenses for the quarter.  Expenses = $5,000 + $2,000 + $15,000 + $1,000 + $1,000 = $24,000
3. Using the Net Income Formula, subtract total expenses from gross income.  Net income = $50,000 – $25,000 = $25,000
4. ABC Company’s net income (or bottom line) for the quarter is $25,000

Operating Net Income Formula

Another useful net income variation to track is operating net income. Operating net income is similar to net income. However, it looks at a company’s profits from operations alone.  Therefore, it does not consider income and expenses that aren’t related to the core activities of the business. Unrelated or non-operational activities include things like income tax, interest expense, interest income, and gains or losses from sales of fixed assets. Operating income is sometimes referred to as EBIT, or earnings before interest and taxes. The formula for operating net income is:

Operating Net Income = Net Income + Interest Expense + Taxes 

Or, put another way, you can calculate operating net income as:

Operating Net Income = Gross Profit – (Operating Expenses + Depreciation + Amortization)

Investors and lenders sometimes prefer to look at operating net income rather than net income. This gives them a better idea of how profitable the company’s core business activities are.

Operating Net Income Formula Example

Let’s return to ABC Company. If ABC wants to calculate the operating net income for the first quarter of 2020, they simply add back the interest expense to net income.

$25,000 net income + $1,000 of interest expense = $26,000 operating net income

Calculating net income and operating net income is pretty basic.  However, it helps if you have good bookkeeping. In many cases, companies have a profit and loss statement or income statement that shows the net income and net operating income. A company’s income statement might even break out operating net income as a separate line item.  Then it will add other income and expenses to arrive at net income as the bottom line.

Net income for a business is found on the income statement.  This number is examined by shareholders, prospective investors, and potential lenders.  They use the information to help determine if the company is solvent and able to pay additional debts.

Where to record net income

Net income is recorded on your business’s income statement. The income statement is one of the three main financial statements companies use.  An income statement shows the profitability of your company. It reports your business’s profits and losses over a specific period. Also, income statements show the process of determining net income.  Total revenues, cost of goods sold, gross income, expenses, taxes, and net income are all line items on the income statement. Net income is the final line of the statement, which is why it is also called the bottom line.

Personal Gross Income vs. Personal Net Income 

For an individual, gross income refers to your total earnings or pre-tax earnings.  Personal Net Income refers to the difference after subtracting deductions and taxes from gross income. The Internal Revenue Service uses the taxable income to determine income tax.  To calculate taxable income, taxpayers subtract deductions from gross income. The difference between taxable income and income tax is an individual’s Net Income.

For example, let’s say an individual has $75,000 in gross income and qualifies for $15,000 in deductions. Therefore, the individual’s taxable income is $60,000 with an effective tax rate of about 15%.  The required income tax payment of $9,000 would result in an Individual Net Income of $51,000.

Income Deductions for Individuals

For cash flow purposes, net income is the equivalent of net pay.  It is the total amount you have earned in a pay period, minus deductions, and taxes.  These deductions can include:

• Social Security taxes
• Medicare and Medicaid taxes
• Health Insurance
• Retirement contributions
• Wage garnishments
• Child support

All of these deductions may not apply to you.  Also, each individual’s tax obligation is different. For example, your company may not provide a retirement contribution plan. Also, net income can fluctuate from a tax perspective depending on which type of retirement plan you contribute to.

Personal Income on Tax Returns 

In the United States, individual taxpayers submit a version of Form 1040 to the IRS to report annual earnings. This form does not have a line for net income. Instead, it has lines to record gross income, adjusted gross income (AGI), and taxable income.

After noting their gross income, taxpayers subtract certain income sources such as Social Security benefits and qualifying deductions such as student loan interest. The difference is their AGI. Although the terms are sometimes used interchangeably, net income and AGI are two different things.  Taxpayers then subtract standard or itemized deductions from their AGI to determine their taxable income. As stated above, the difference between taxable income and income tax is the individual’s NI, but this number is not noted on individual tax forms. (Source:investopedia.com)

Individual Income on Paycheck Stubs 

Most paycheck stubs have a line devoted to Net Income. This is the amount that appears on an employee’s paycheck. The number is the employee’s gross income, minus taxes, and retirement account contributions.

Net Income Frequently Asked Questions (FAQs):

What does negative net income mean?

Negative net income on a company’s income statement means that the company’s expenses added up to more than its revenue. As a result, the organization experienced a net loss over that period. Generally, when a company’s net income is low or negative, many different problems could be the cause. These can range from declining sales to an economic downturn to improper expense management.

If a company has high net income, does it also have positive cash flow?

Not necessarily. Net income is not a measure of how much cash a company earned during a given period. The income statement includes a lot of non-cash expenses, like depreciation and amortization.  To understand how much cash a company generates, you need to examine the cash flow statement.

What’s the best way to compare income between companies?

Net income varies greatly between companies and industries. It is often more appropriate to consider net income as a percentage of sales.  This is also known as a profit margin.  Net income plays a key role for investors when they compare company earnings using the price-to-earnings (P/E) ratio. This ratio lets investors compare how much they are paying for each dollar of net income that the company is able to generate.

What is EBIT -Earnings Before Interest and Taxes?

Some investors also look at EBIT (earnings before interest and taxes) and EBITDA (earnings before interest, taxes, depreciation & amortization). These numbers are similar to net income, except they exclude several expense items.

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