Your small business is getting traction through an ecommerce website. Sales have risen for six straight months, you hired two assistants, and you started a marketing and advertising campaign through magazines and social media. The bank loan you obtained three months ago let you hire staff and buy advertising.
Then your accountant friend says that all sounds great, but asks: “How’s your net income?’’
Your reply: “My WHAAAT?” Sales growth has been your main focus. Now you need to pay more attention to expenses, and determine if your business is making—or losing—money.
What is net income?
Net income is your final profit—what’s left after your business adds up all revenue and subtracts all expenses, including taxes. It’s the most-watched and most-cited measure of a business’s success. Net income is often referred to as the bottom line, because it’s at the bottom of a business’s income statement—the last line after accounting for all revenue and expenses. It’s also referred to as net profit or earnings, or in the case of a loss, negative net income.
Larger businesses, often organized as corporations with shareholders, account for net income each quarter and year, and their accounting is more complex. Small business income statements typically are simpler and may be calculated monthly.
Think of net income like take home pay. Let’s say an employee at a company has a monthly salary of $5,000. This is called gross pay, or gross income. After an employee makes a pretax contribution to the company’s 401(k) retirement plan, and money is withheld for income taxes and Social Security taxes, they are left with $3,500. This amount is, in effect, personal net income.
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A key difference between business net income and personal net income is the business has already subtracted its overhead costs or general expenses, such as rent, utilities, payroll, and office supplies. An individual’s net income doesn’t account for those expenses. So in the example above, $3,500 in monthly take home pay would be used to pay for housing, utilities, phone, cable TV, food, transportation, and other expenses.
Importance of net income in business
Net income indicates a business’s profitability to the owners, lenders, or outside investors. Examined over a period of time, net income can signal the long-term viability of the business.
Profitability is expressed in dollar figures or in percentage terms, called profit margin. In other words, for each dollar of revenue, how much profit is left after expenses?
For example, a hypothetical business, ABC Overstock Fashions Inc., had a net income of $500,000 in the recent quarter and revenue of $2 million. Its net profit margin was 25%, or 25¢ of profit for each dollar of revenue:
$500,000 / $2,000,000 = 0.25 or 25%
Other profit margins include gross margin, which reflects profit after subtracting only expenses directly tied to production but excluding overhead costs; and operating margin, which accounts for overhead but not interest payments and taxes. Gross profit and operating profit margins usually are higher than net income because they don’t account for all expenses.
So revisiting the case of ABC Overstock, the gross profit margin might be 50%, because it only includes production costs, while the operating profit margin might be 35%, because it adds in overhead expenses.
The purpose of calculating net income and profit margins is to compare performance over time. The owners or managers can use this information to analyze trends and make decisions on expanding and borrowing, distributing profit to shareholders, or seeking new investors.
Lenders examine net income and profit margins when considering business loan applications, and investors weigh a business’s profitability in deciding to offer funds in return for a stake in the business.
Factors that can affect net income
Business profitability can rise or fall, depending on the interplay of the following items:
- Changes in revenue. An increase in total revenue leads to higher net income, just as a decline in revenue lowers it, assuming other factors don't change. All or most revenue typically comes from sales of products or services, while other types of revenue, such as rental income or income from investments, usually are minor.
- Changes in expenses. Conversely, an increase in total expenses will reduce net income, unless revenue increases proportionately. Net income also can be affected by non-cash expenses such as depreciation of the value of operating assets. A business that spends $10 million for machinery and expects it to last five years, for example, might record a non-cash depreciation expense of $2 million for each of the next five years.
- Changes in tax laws. Tax rates changed in recent years, and may change again. The rate for corporations was lowered in 2018 to a flat 21%, from a previous series of graduated rates with a top rate of 35%. (In 2022, the Biden administration proposed raising the rate for corporations to 28%.)
Businesses operating as sole proprietorships (one owner), partnerships, or S Corporations are not taxed directly, because net income is passed through to the owners or partners, who pay federal taxes based on their individual tax brackets. In 2023, these rates ranged from 10% to 37%.
State taxes on business income vary as well, ranging from 2.5% to 12%, although some states have no tax.
How to calculate the net income of a business
Many small businesses can calculate net income with a simple process called a single-step income statement, starting with revenue and then subtracting a straight list of expenses and taxes.
Bigger businesses use a more complicated net income formula, known as a multistep income statement, showing the progression from revenue to gross income to operating income to net income. Such a calculation might look like this:
|
Revenue |
$10,000,000 |
|
Cost of goods sold |
-6,000,000 |
|
Gross income |
4,000,000 |
|
Selling, general & administrative expenses |
|
|
Rent |
-700,000 |
|
Utilities |
-50,000 |
|
Phone/Computer/WiFi |
-25,000 |
|
Payroll |
-150,000 |
|
Marketing/advertising |
-35,000 |
|
Office supplies |
-20,000 |
|
Miscellaneous |
-20,000 |
|
Operating income |
3,000,000 |
|
|
|
|
Interest on $5 million loan, 5% |
-250,000 |
|
Taxes |
-550,000 |
|
Net income |
$2,200,000 |
Net income FAQ
How do you calculate net income?
Net income is calculated by subtracting all expenses and taxes from revenue or sales. A simple calculation might be revenue minus a handful of expenses; a more complex calculation would first determine gross income, then the operating income, and finally the net income.
Is net income different from cash flow?
Net income often is different from cash flow. Because net income makes assumptions about revenue and expenses in a given period, it can include revenue not yet collected, as well as non-cash expenses, such as depreciation. Cash flow only accounts for actual cash transactions—money received and money paid by the business during the period.
Is net income the same as gross profit?
Net income is different from gross profit, also called gross income. It’s usually lower than gross profit because it accounts for all expenses, including taxes. Gross profit only accounts for expenses directly associated with products or services sold, and does not include overhead, interest payments, or taxes.
