Amazingly, a simple mathematical operation can tell you how your company’s finances are doing and help you improve its performance. Having the power to do this is the perfect tool to keep in your arsenal.
Learning how to calculate the net income of your business will not only be able to help you cut unnecessary expenses but also it will help you know your financial capabilities when you access business loans, make a realistic business plan, and avoid debt.
In this article, you’ll learn what the net income is and why it is essential to know this metric. Also, we’ll teach you, step-by-step, how to calculate net income.
What is net income?
Before going straight to the net income formula, it is necessary to delve into this concept and understand it.
Net income is the total profit of a company in any given period. In other words, this indicator tells you if you are making money or not.
It is a fairly reliable method to determine the profitability of your company.
Net income is obtained by subtracting expenses such as payroll, taxes, and utilities from total business sales.
If operating expenses and costs are higher than income, this means that the business has a net loss, which could be due to decreased sales or poor management.
Have you heard of discretionary income? Learn more in our article.
Why do you need to determine net income?
Knowing how to calculate net income can be useful in more than one way:
- It lets you know how much money you make and if you pay too much to keep your business running. If your income is insufficient, this metric will show you where to make adjustments, and how to organize your business financially.
- It can help you access a business loan. Lenders will want to take a look at your company’s net income to assess its financial status and to make sure you can pay your debts.
- Net income tells investors if your business is profitable. When a company keeps a good part of its profits, it is quite likely that a high percentage will pass to its shareholders in the form of dividends. It can also be reinvested in the business.
How to calculate net income?
It is super easy to determine net income of your business. You only need a simple formula:
Net Income = Profits – Cost of Goods Sold – Expenses
To make it easier to understand, let’s review each of these concepts:
- Profits. It is the money that enters the company in a specific period in the form of cash, checks, and card payments.
- Cost of goods sold. They are the production costs of the goods that your company sells. These include materials and labor.
- Expenses. They include taxes, payments to suppliers, machinery and equipment, leases, advertising, water and electricity, maintenance and repairs, transportation expenses, among others.
So, net income is obtained by subtracting the costs of goods sold and expenses from your company’s profits.
How to calculate net income: an example
With the following example, you will better understand how to calculate net income. Imagine Miguel owns a restaurant and wants to know what his earnings were during the first year.
How do I calculate my annual net income?
To begin, Miguel has to know the total of his earnings during this period. Let’s say these amounted to $100,000.
Then he will have to subtract the cost of goods sold (the ingredients for his dishes, for example), which was $30,000.
Between operating expenses, taxes, marketing, and other costs, he had to spend $35,000 for the entire year. If you remember the formula, these expenses must also be subtracted from the total earnings. So…
Net Income = Profits – Cost of Goods Sold – Expenses
Net Income = $ 100,000 – $ 30,000 – $ 35,000
Net Income = $ 35,000
Thus, Miguel made a profit of $35,000 in the first year.
Now that you know how to calculate it, learn how to report your small business income.
Profit and Loss statement, or P&L
The net income of your business, as well as other data, should be recorded in a document called “Profit and Loss Statement,” also known as P&L.
This report is essential when preparing taxes or applying for certain loans. The document must meet specific parameters:
- Company name, and the date of the report.
- The gross income of the business.
- Legitimate business expenses in alphabetical order.
- Depreciation taxes and expenses, shown as separate deductions.
- The document ends with the net income.
Net Income vs. Net Profit
There can be confusion when talking about this indicator, as accountants use terms such as net income, net profit, or net earnings interchangeably to talk about the same thing: the money left after subtracting expenses and the cost of goods sold from the earnings.
Net Income vs. Gross Income
Now, there is a difference between gross income and net income. Your company’s gross income represents the amount of money it receives from the sale of products and services, minus the cost of goods sold.
When we deduct administrative and tax expenses from gross income, we obtain net income, which, by the way, is also known as “the final result” or “the bottom line”, since they appear until the end in the financial results of a company.
Gross Income = Profits – Cost of Goods Sold
Net Income = Gross Income – Expenses
It is an excellent idea to learn how to calculate net income
Knowing how to calculate the net income of your business will allow you to understand what the state of your finances is and how much you really earn. This way, you can cut unnecessary expenses and make other adjustments.
Besides, this indicator serves as a kind of “financial compass”, and can be useful to access commercial loans or to show shareholders and future investors how profitable your company is.
Calculating net income is very easy. You just have to subtract the cost of goods sold and business expenses from all profits. Net income must be recorded in a document called a financial statement of profit and loss.
Finally, net income and net profits are two different terms to name the same concept. There is no need to get confused!
At Camino Financial, we do not leave any businesses behind. We want to make sure that you receive the best financial resources so that you can plan the future of your company correctly.