How to calculate net income
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Net income is a crucial factor that all business owners must consider. It’s not just a number on a financial report, but rather the lifeblood of the business—and it can be tricky to calculate.
That's why we put together this comprehensive guide on how to calculate net income to help you make the most of your SMB or micro-SMB.
What is net income?
Net income is the total amount of money your business makes after deducting all expenses, allowances, and taxes. Net income gives insights into profitability, expense management, and the ability of the business to generate cash flow for reinvestment. When tracked over time, net income helps owners identify patterns or trends that could indicate potential areas for improvement and areas where business is already strong.
Net income is also essential in assessing the effectiveness of a business in managing expenses. Monitoring net income regularly can help owners determine whether their pricing strategy needs to be adjusted to accommodate changing costs or if certain investments are needed to increase profitability.
Steps to calculate net income
Before calculating net income, it's crucial to gather all financial data for a specific period. Without all of the data, your net income won't be entirely accurate. This includes sales numbers, expenses, payroll, taxes, and depreciation. This data is normally collected from the general ledger and should be organized into a spreadsheet. The use of accounting automation software can also simplify this process.
Once the necessary data has been collected, follow these steps to calculate your net income:
1. Determine your total revenue
Total revenue is the amount of money a business generates in a given period. The money is generated from the sale of products and services. It may also include other payments made to the business. Total revenue is also known as gross revenue.
2. Calculate and deduct total expenses
Total expenses are the costs incurred by running a business. These include administrative, marketing, and operation expenses. Examples of expenses include salaries, cost of goods, rent, advertising, and insurance premiums. For example, if a business spent $500 on salaries and $300 on office supplies in a month, the total expenses for that month would be $800. Make sure not to leave out anything, even if it's extremely small. You want your final numbers to be as accurate as possible.
3. Deduct depreciation
Depreciation is the loss of an asset value over time due to wear and tear or obsolescence. It is a non-cash expense that does not involve the physical transfer of funds. Businesses use depreciation to spread the value of an asset over its useful life. The amount of depreciation is calculated based on the asset's purchase price and estimated useful life. Depreciation is therefore deducted from revenue to determine pretax income.
4. Deduct taxes
At this stage, the amount remaining is called the pre-tax income. This is the amount of money left after all costs and depreciation have been deducted before taxes are considered. Taxes are calculated based on the business's income, and the rate of taxes varies depending on several factors. The amount of tax is then deducted from pre-tax income, leaving you with net income.
5. Calculate net income
The net income of a business is the amount left after all costs, depreciation, and taxes have been deducted. This is also known as the bottom line, the final figure that businesses use to measure their profitability. The net income of a business shows how much money a company has made or lost over a given period. By calculating your net income, you can determine the financial health of your business and make informed decisions on how to improve profitability.
Example of a net income calculation
Let's walk through how to calculate net income for a business that generated $1,000,000 in revenue. The business incurred expenses totaling $600,000, including salaries and cost of goods. Its depreciation expense was $50,000, and its tax was $150,000.
The formula we’ll use to calculate net income is the following:
Revenue – Expenses – Depreciation – Taxes = Net Income
Here’s how it applies to the example above:
- First, subtract all expenses from the revenue ($1,000,000 - $600,000 = $400,000)
- Next, subtract the depreciation expense to arrive at the pretax income ($400,000 - $50,000 = $350,000)
- From the pretax income, subtract the tax as follows to arrive at the net income ($350,000 - $150,000 = $200,000)
After accounting for all expenses and taxes, the business earned a net income of $200,000.
Why is calculating net income important?
Calculating net income off an income statement is an essential accounting tool that helps businesses track revenues and expenses. It helps owners understand how much money they are making and spending.
The following are some reasons why it's important to calculate net income:
- Identify operational costs and profits: Knowing how much money you are making or losing is key to running a successful business. Understanding net income provides insight into the financial health of your company.
- Plan for tax season: Calculating net income is important for determining how much you will owe. This information is crucial to plan and budget appropriately to pay tax liabilities.
- Create accurate financial statements: Calculating net income is needed to create balance sheets and income statements that accurately reflect your company’s overall financial performance.
- Attract investors and qualify for loans: An accurate net income figure helps your business attract potential investors or qualify for loans from banks, as it provides a clear financial picture of your company.
Save your time and money today with Ramp
It's no secret that running a small or micro-sized business can be tough. Tight budgets, long hours, and constant pressure to make more profit can feel overwhelming. That's where Ramp comes in. With Ramp, you can efficiently calculate your business' net income with high accuracy and no manual effort needed. We also offer services such as expense management, accounting automation, bill payments, corporate cards, and reporting—all in one finance platform.
Contact us today to discover how Ramp can simplify your finance management.