A strong business knows its numbers, but a great one leverages them.
To build a successful business and keep it successful, entrepreneurs must have a clear understanding of their financial health and operational efficiency.
This is exactly what the metrics net income helps with. It provides necessary insights about profitability, costs, and sustainability, helping the owners make informed strategic decisions for their business.
In this blog post, we’ll understand how to calculate net income by discussing formulas, components, and their importance. We’ll also understand what operational net income is with its formula.
But before that, let’s clarify the basics.
What is Net Income?
Net income is an important business metric used to measure the profitability of the business. It is calculated by subtracting total expenses—including operating costs, interest, taxes, and depreciation—from total revenue.
The resulting amount is the net earnings of your business, i.e. profit.
Let’s now understand how to calculate the net income from the balance sheet using a formula.
Net Income Formula
You can calculate net income using the comprehensive method and the simplified method.
Comprehensive Method
In this method, net income is derived by deducting the cost of goods sold (COGS) and expenses from the business’s total revenue. You can calculate the net income using the below formula:
Net income is often referred to as net profit, net earnings, or bottom line as it appears at the bottom of the income statement. To calculate your net income, subtract all expenses from the total revenue generated in the specified period.
Net income is used to cover daily costs, pay off your business debts, make capital investments, or distribute dividends to shareholders.
Simplified Method
This method of calculating net income uses gross income and deducts total expenses from the same. The simplified formula for net income is listed below:
The simplified method focuses on the difference between the total income received and the total expenses incurred, making it the easiest way to measure a business’s profitability
Your net income can be positive or negative. When it’s negative, it indicates that your expenses were higher than the income you generated for your business.
Let’s understand the net income formula with the help of an example:
Net Income Formula: An Example
Suppose a clothing retailer in Houston, Green Leaf LLC, wants to calculate his net business income for 2021. Here are the details:
| Particulars | Amount |
|---|---|
| Total Revenue | $85,000 |
| Cost of Goods Sold | $33,000 |
| Salary | $12,000 |
| Electricity | $2,500 |
| Office Rent | $5,500 |
| Marketing Expenses | $1,900 |
| Interest on Loan | $1,100 |
| Taxes | $1,000 |
Let’s help the retailer in calculating his business net income using both methods:
Net Income Calculation Using Comprehensive Formula
Hence, $85,000 – $33,000 – ($12,000+$2,500+$5,500+$1,900+$1,100+$1,000) = $28,000
The net income of Green Leaf LLC is $28,000.
Net Income Calculation Using Simplified Formula
Now, Gross Income = Revenue – Cost of Goods Sold
Hence, $85,000-$33,000 = $52,000
Expenses = $12,000+$2,500+$5,500+$1,900+$1,100+$1,000 = $24,000
Net Income = Gross Income – Expenses
$52,000 – $24,000 = $28,000
Key Components of Net Income
Here are a few components you need to understand to accurately calculate your business’s net income.
Revenue
Revenue refers to the income you generate from your business, and it will include all other revenues, such as profit from the sale of an asset.
Cost of Goods Sold
The cost of goods sold (COGS) refers to the expenses incurred to run your business’s main operations, such as raw material costs.
Expenses
These expenses include all the costs that are not directly tied to the production, i.e. office rent, utility expenses, etc.
Why is Business Net Income So Important?
Apart from measuring business profitability, net income helps understand how efficiently you use the resources to generate revenue for your business.
While negative net income is unfavorable for any business, it’s quite normal for a new startup to have negative net income during the first 2-3 years.
However, if it continues longer, it’s an alarming signal that the business may not be successful.
Your income statement analysis helps manage your expenses and increase your net income.
What is Operating Net Income?
The operating net income refers to your business’s net income from main operations, excluding the income and expenses unrelated to your main business. You require operating revenue and operating expenses to calculate the operating net income.
It is also referred to as ‘Earnings Before Interest and Taxes (EBIT)’.
Operating Net Income Formula
Since the operating net income is an income before deducting interest and tax expenses, you can calculate it by adding these expenses to the net income.
Alternatively, the formula to calculate operating net income can also be as follows:
Operating Net Income Formula: An Example
Let’s continue with our previous clothing retailer’s example.
According to the table, the interest expense during that period was $1,100 and the retailer’s tax expense was $1,000.
The net operating income in this case would be
$28,000(net income) + $1,100(interest) + $1,000(tax) = $30,100.
Or
Net operating income = $85,000(revenue) – $33,000(COGS) – ($24,000-$1,100-$1,000) = $30,100
Concluding Thoughts
Calculating the net income is quite easy if you have all the necessary details. However, calculation alone isn’t enough. You need to interpret your net income and take strategic actions to improve your business’s performance.
Remember, net income can be used to calculate multiple ratios which can offer insights to improve the financial performance of your business. It’s important to calculate it accurately as it forms the base for various other financial ratios.
With the Upmetrics business planning app, you can create detailed financial statements for your business and calculate essential ratios and net income in a jiffy. It’s efficient, time-saving, and eliminates the possibility of manual errors.
