How to calculate net income

Net income helps you assess your profitability. Also known as the bottom line, it represents the total amount of money your business retains after subtracting business expenses from total revenue.

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.

Key terms

• Gross income: Gross income is calculated as total revenue minus cost of goods sold (COGS). It doesn’t include operating expenses, taxes, or interest expense.
• Operating income: This is gross income minus operating expenses, such as salaries and rent. It’s income generated from regular business operations before accounting for taxes and interest.
• Net profit: Often used interchangeably with net income, net profit is the final profit after all business expenses, including non-operating expenses

Net income is also essential in assessing the effectiveness of managing business 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.

How 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

Begin with total revenue from sales of goods or services. This is the sum of all incoming funds your business has earned over a given period.

Example:

A small retail store generates $500,000 in total revenue from sales in a year.

2. Subtract cost of goods sold

Cost of goods sold (COGS) refers to the direct costs involved in producing goods or services, including raw materials, labor, and production expenses. This step determines how much money you made after covering the costs of producing the products you sell.

Example: For the retail store, COGS for the year is $250,000—cost of inventory, labor costs for manufacturing, etc.

Formula:

Gross income = Total revenue – COGS

Gross income = $500,000 – $250,000 = $250,000

3. Subtract operating expenses

Operating expenses include all the costs required to run your business, such as administrative expenses, marketing, salaries, and rent. These are subtracted from gross income to calculate operating income.Example:Operating expenses for the year are $100,000, including rent, utilities, and salaries.Formula:

Operating income = Gross income – Operating expenses

Operating income = $250,000 – $100,000 = $150,000

4. Account for non-operating expenses

These expenses are not related to your core business activities, such as interest expense and tax expense. These must be deducted from operating income to calculate net income. Example: The business pays $10,000 in interest expense and $25,000 in taxes for the year.

5. Calculate net income

After subtracting interest, taxes, and depreciation, net income is your final figure. This is the bottom line on your income statement and reflects your company’s overall profitability.Example:After subtracting interest expense and taxes, the final net income for the store is $150,000 – $10,000 – $25,000 = $115,000.

Formula:

Net income = Operating income – Interest expense – Tax expense

Net income = $150,000 – $10,000 – $25,000 = $115,000

Key components of net income

Understanding the components will help you make more accurate calculations. The most important factors to know about include:

Why is calculating net income important?

Calculating net income off an income statement helps businesses track how much money they are making and spending.

This is key for various stakeholders, including business owners, investors, and creditors:

• For business owners: Net income helps assess whether the company is profitable after all expenses. It informs pricing decisions, budget management, and long-term strategy.
• For investors: Investors look at net income to assess a company’s ability to generate profits and its financial health. Net income plays a role in determining a company’s earnings per share (EPS), which is critical for stock valuation.
• For creditors: Lenders and creditors evaluate net income to determine whether a business generates enough cash to meet debt obligations. A strong net income suggests a lower risk of defaulting on loans.

Common mistakes in calculating net income

While calculating net income, avoid these pitfalls:

1. Not including all expenses: Some businesses mistakenly overlook expenses such as interest expense or tax expenses, which can lead to an inflated net income figure
2. Miscalculating depreciation: Make sure you depreciate tangible and intangible assets to avoid overestimating profits
3. Ignoring non-operating income: You should include non-operating items such as interest income or investment returns in the final calculation

How net income drives investment and lending decisions

Net income is not just an internal measure; it plays a crucial role for external stakeholders:

• Investors: Net income helps investors evaluate whether a company is profitable and provides insight into its potential for future growth. It’s often used to calculate important metrics such as earnings per share (EPS) and price-to-earnings (P/E) ratio.
• Creditors: Net income is also crucial for creditors, who evaluate whether a company can generate sufficient cash flow to repay its loans. Strong net income increases the company’s ability to secure loans with favorable terms.

Save your time and money with Ramp

Understanding and accurately calculating net income helps you improve your business’s financial health. By staying on top of your income and expenses, you can make informed decisions that drive profitability and growth. However, managing your finances manually can be time-consuming and prone to errors.

Ramp’s accounting automation software simplifies your financial processes, from expense tracking to real-time reporting. By automatically logging and categorizing transactions, Ramp helps you stay organized and accurate without the hassle. With customizable features like corporate cards and powerful reporting tools, you can control your spending and optimize your budgets.