Because it represents the overall amount earned by a company’s stockholders for a particular period, net income is the strongest predictor of its profitability. However, net income is more than meets the eye. For example, did you know that dividends paid to preferred shareholders are not considered an expense and have no effect on your net income?
Continue reading to find out everything a firm needs to know about net income.
What is Net Income (NI)?
Net income is often referred to as net earnings. It is computed as a company’s total sales revenue minus general expenses, costs of goods sold, taxes, operational costs, and any other expenses. To calculate an exact net income, you must account for all expenses.
A net income formula is one of the finest techniques to compute net income. The formula is specifically created to assist businesses or investors in obtaining reliable analytics of the company’s profit earned over a specified time period. All you have to do is make sure that gross figures and expenses are entered into the appropriate categories before calculating.
Net Income in Business
Important net income factors in business include:
- Accounting method
- Basic vs. multi-step income statement
- Ways to categorize business expenses
- EPS and earnings presentations
#1. Accounting Method
In order to calculate net income in a business, you must first choose an accounting method. GAAP (generally accepted accounting principles) mandates accrual accounting above cash basis accounting.
Some small business taxpayers who do not have inventory are eligible to use the cash method of accounting rather than accrual accounting to determine net income on their tax returns. To keep only one set of books, they can use the same cash technique for business financial statements. The standards for permitting the cash method of accounting for income taxes are set by the IRS. Request that your CPA firm evaluate the best accounting approach for your organisation.
Calculating net income in a business using accrual accounting requires appropriate revenue recognition, matching revenue and expenses in the same accounting period, and taking into account non-cash expenses such as equipment depreciation and intangible asset amortization.
#2. Multi-step income statement
Gross profit less cost of goods sold (COGS) is determined in organizations that use a multi-step income statement with a financial statement subtotal line of gross profit before operating expenditures are deducted.
#3. Ways to Categorize Business Expenses
Selling, general, and administrative expenditures (SG&A), research and development (R&D), and any other types of expenses connected to their business operations are all included as operating expenses. Marketing expenses are included in the SG&A line item in this situation. Some businesses report general and administrative expenses (G&A) as a separate line item in their income statement’s operating expenses section.
Management accountants in organizations may further categorize expenses into fixed vs. variable categories for internal financial analysis in order to assess their contribution margin, variable expense ratio, and breakeven point. Variable costs are direct costs that change in relation to volume.
Splitting expenses into variable and fixed expenses can help with product pricing, deciding whether to accept particular orders at a cheaper price, and doing breakeven analysis.
#4. EPS and Earnings Presentations
Businesses may also report basic and diluted profits per share (EPS) on their income statements, with net income serving as the earnings amount.
In their SEC company filings and news announcements for quarterly and annual financial statements, public corporations frequently declare GAAP earnings and non-GAAP earnings that are reconciled to net income per GAAP financial statement.
Reasons Why Net Income Is Important for a Business
Net income (or net profit) is important in many business decisions. Here are some examples of how important net income is:
#1. Determine Trends Towards Profitability
VC-backed startups and high-growth enterprises aren’t expecting to make a profit when they look at their bottom line. Most of the time, you’re making a net loss as you use venture capital to fuel expansion and aim to gain as much market share as possible on your road to an IPO.
However, tracking net income trends can help you determine whether your company is on a path to profitability, even if it is losing money. Because, even if you aren’t expected to be profitable right now, it is always the ultimate goal of any firm.
#2. Keep an eye on your financial health.
Net income is useful for monitoring your company’s financial health, especially if it is publicly traded. If your net income is regularly low, you need to figure out where the money is going.
Aside from that, a low net income can lead to other financial problems. A firm that has issued cumulative preference shares, for example, creates a liability if it is unable to pay dividends every year.
This means that once the company’s net income has stabilised, it will require time to pay off the preference share distributions before it can pay dividends to equity owners.
The more precise your revenue forecasting, the easier it is to develop predictability in your financials and handle concerns that would have a negative impact on net income.
#3. Make a Growth Strategy
Companies in high-growth industries, such as SaaS, require capital to maintain their growth. They keep a portion of the net income and deposit it in a fund called retained earnings for growth.
The net income of a corporation indicates how much money can be transferred to retained earnings and reinvested in the organisation.
How to Calculate Net Income
You can use multiple net income formulas to determine net income based on whether you want a simple or multi-step calculation.
Basic Net Income Formula:
Net Income = Revenue – Total Expenses
Multi-step Net Income Formula:
Net Income = Revenue – Cost of Goods Sold = Gross Profit – Operating Expenses and Costs = Operating Income – Non-operating Expenses and Costs – Net Interest Expense = Net Income Before Taxes – Income Taxes
The operating profit, which reflects a company’s profitability from operating activities, is another name for the subtotal operating income. Net interest expenditure is a sort of non-operating expense that appears as a line item on a multi-step financial statement.
The net income computation is divided into five independent net income formulas that are utilized in a multi-step income statement.
Limitations on Net Income
Let’s look at the net income figure’s limitations to gain a better understanding of your company’s net earnings.
Here are some limits to be aware of:
#1. Effect of Accounting for Non-Cash Expenses
Depreciation and amortization are not cash expenditures. You do not pay for those charges. While they are useful in accounting, they frequently skew the net income statement.
This is especially true if the market value of your assets falls. Assume your certified public accountant (CPA) advises you to reduce the value of your asset from £10,000 to £7,500. In that situation, your income statement will show a £2,500 expense, and the asset’s value will decrease by the same amount on the balance sheet. However, you will not be paying that £2,500 to anyone.
In other words, non-cash expenses reduce your net income but have no effect on your earnings outside of the books.
#2. Multiple Assumptions
Accountants make assumptions in financial statements that may distort your net income. For businesses that possess manufacturing equipment or sell tangible items, asset depreciation is a common example.
To reduce their net income in the books, business owners that want to reduce their company’s income tax bill often choose a large depreciation expense on their tax books.
A corporation seeking investors, on the other hand, may employ a reduced depreciation charge on its accounting books to inflate its net income.
#3. No-Fix Correlation with Cash
Does a net income of £100,000 in a year imply that you created £100,000 in cash during that time?
Not quite.
Because accrual accounting allows organizations to record revenue or expenses before the actual exchange of cash, your total net income differs from the cash your business generates throughout a period.
This is where your income statement and cash flow statement must be cross-referenced.
Other Names for Net Income
Because it shows at the bottom of the income statement, net income is also known as net profit, net earnings, net income after taxes (NIAT), and the bottom line. A net loss is defined as a negative net income (where expenses exceed revenue).
#1. Net profit
The terms net income and net profit are frequently used interchangeably. Profit, on the other hand, refers to what remains after expenses and can be employed in other computations. For example, gross profit equals revenue less the cost of goods sold (COGS). So, keep in mind the sort of profit mentioned (net profit, gross profit, etc.) to ensure that you’re using net profit as the correct synonym for net income.
#2. Net earnings
Another method of referring to net income Earnings are profits after expenses and liabilities, including taxes, for your organisation.
Other Financial Terms That Are Commonly Confused with Net Income
The only sort of profit that appears on the financial accounts is net income. You’ll also see gross income, EBITDA, and EBIT. You’ll also come across taxable income if you check through the tax books.
#1. Gross Income
The term gross income (or total income) occurs at the top of the income statement. It is calculated as follows:
Gross Income = Revenue – COGS (Cost of Goods Sold)
As a SaaS company, you can determine your gross profit by removing your service costs from your total revenue.
For example, you can compute gross profit by removing from revenue expenses like as server costs and payments made to freelance software engineers.
Gross profit is a financial efficiency metric that can help you assess how well your firm performs its services.
#2. EBITDA
The acronym EBITDA stands for “earnings before interest, taxes, depreciation, and amortization.”
It is calculated as follows:
EBITDA = Net Income + Taxes + Interest + Depreciation + Amortisation
EBITDA measures a company’s profitability without accounting for tax provisions, financing costs, or capital expenditure.
Companies are not required to display EBITDA on their financial statements under US GAAP, the SEC, or the IRS.
However, because EBITDA is routinely utilised for corporate valuation, many corporations include it on their financial statements. For example, investors frequently utilise EV/EBITDA to analyse firms and identify interesting investment opportunities.
Investors often rely on sales multiples for SaaS valuation, therefore EBITDA isn’t as useful in this context.
#3. EBIT
EBIT stands for “earnings before interest and taxes.” It is calculated as follows:
EBIT = Net Income + Taxes + Interest
EBIT lets you understand how effective your business management is. For example, if your EBIT is low while your gross income is large, you’re spending too much on administrative expenses. You must also explore alternatives.
Companies, like EBITDA, are not required to declare EBIT in their financial accounts.
However, because EBIT is also used for value, many people share it. A typical EBIT valuation metric is EV/EBIT.
Is Net Income Your Salary?
Your net income does not equal your wage. Salary is a source of income stated on a personal financial statement and a component of gross income on a tax return for people.
Can Net Income be Negative?
Yes. A net loss occurs when the calculation of net income results in a negative sum. The net loss can be expressed with a minus sign on an income statement (profit and loss statement) or in brackets. A corporation with a positive net income is more likely to be in good financial standing than one with a negative net income.
What is Net Income vs. Gross Income?
Net income is defined as gross income minus expenditures and expenses. Gross income is the same as revenues on a firm’s financial statement. Gross income for an employed person includes a variety of sources of income, including:
- Earned wages or salaries, bonuses, and sales commissions prior to payroll deductions
- Investment income
- Real estate rents received by a landlord
- Other miscellaneous income
What is Net Income vs. Cash Flow?
Net income differs from cash flow in accrual accounting. An indirect cash flow statement reconciles net income with cash flow from operations by reversing non-cash expenses such as depreciation and amortization, as well as changes in account balances for various types of working capital within the accounting period.
Working capital balance adjustments, such as an increase in accounts receivable or a reduction in accounts payable, necessitate subtractions rather than additions in this net income to cash flow from operations conversion. Changes in working capital balance reflect changes in a company’s use of cash.
Is EBIT the Same as Net Income?
No. Earnings before interest and taxes are referred to as EBIT. Earnings after interest and taxes are referred to as net income. As a result, unlike net income, EBIT is not the last line of the income statement. EBITDA is an abbreviation for earnings before interest, taxes, depreciation, and amortisation. The relationship between net income and EBITDA is not the same.
Conclusion
Businesses value net income because profitability drives company success. Businesses can use net income to compensate its stakeholders, such as employees who receive bonuses and stockholders. Larger public firms with significant net earnings can continue to pay dividends.
If a company earns net income, it may be accepted for credit lines or bank loans to support business operations and expansion.
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