What Is Net Income?
Updated July 21, 2022
If you are starting or running a business, calculating the company's net income can help you understand profitability and identify any future changes. If you are self-employed and receive income from various sources, the ability to collect those numbers and analyze them properly will help you be clear on your income potential. In this article, we discuss how to calculate net income and how understanding it can be helpful to your business.
What is net income?
Net income is the total revenue earned in a given time period after deducting total expenses. You start by identifying your gross income, which is the revenue you have gained over a set period of time without deducting any operating or business expenses like a lease, interest payments or payroll. After identifying those expenses, you add them together and deduct them from the gross income, and the remaining number totals your net income.
Why understanding net income is important
Calculating net income accurately for a business of any size is important for a variety of reasons:
It helps you see your overall expenses. When paying individual bills throughout the year, it can be challenging to see if your expenses are cutting into your profit. Awareness of each one and how it affects the overall profitability of your company can help you analyze each individually and see if a series of smaller cuts may affect your net income significantly. This number is relevant to shareholders for larger companies and is helpful in making decisions that help a small business grow and thrive.
It helps you understand the health of your business. If your operating costs are impacting your income significantly year after year, it may be time to reevaluate what you can change or reduce to make sure your business can remain profitable long-term. Focusing on profit helps you prepare for changes in the economy or the market in which you operate. For a company that produces goods, you may analyze whether your production methods or location cost more than the market price of the item.
For a self-employed contractor, you may decide to work from home rather than keep paying the costs associated with renting an office space. When you know your total net income every quarter or year, you can analyze and make these decisions frequently and remain conscious of how your business is performing.
It helps you know if your decisions are profitable. Businesses large and small have to constantly make decisions, such as the number of employees and their salaries and benefits, what to charge for your goods and services, the right size office for your needs and which products are most profitable. Considering the answers to these questions combined with knowing your net income allows you to look at your biggest expenses and make sound financial decisions.
It helps you report accurately. Accurate and honest company accounting helps you pay taxes correctly to avoid any penalties in the future. It helps you see clearly what any tax liabilities will be so you can plan and save to pay on time. And it allows larger or public companies to pay their investors what they are due.
How to calculate net income
Properly calculating your company's net income is necessary to accurately report your balance sheet. Follow these steps to calculate net income:
1. Calculate your annual gross profit
Gross income is the amount of money you took in from sales, customer payments or invoice receipts. The gross income does not deduct any operating costs except for the actual cost of the product itself. For example, if you're a clothing manufacturer, you have to purchase the materials to manufacture the clothing. Deduct only the direct cost you pay to produce the good.
2. Calculate your indirect operating costs
Your indirect costs may vary year-to-year and may include costs like:
Rent, lease or mortgage payments on your office or retail space
Utilities like electricity and water
Office supplies like computers, desks and decor
Marketing expenses like advertising or mailers
Travel, including plane tickets or vehicle travel expenses like mileage and repairs
Legal and professional fees, such as paying an accountant or consultant
3. Calculate allowable deductions
Depending on where you live, deductions may include depreciation for company property, healthcare costs, charitable donations, insurance or professional fees. This number helps you know what your tax expense will be. The IRS bases income tax on this net figure.
Calculating net income example
Here is a simplified example of calculating net income:
You run a small business with two part-time freelance employees making hair bows for children. You sell the hair bows online through an e-commerce site and also provide inventory to local boutiques in your area. You work out of your home, and your two employees each work in their homes in other cities and ship the finished bows to you.
At the end of the year, you calculate that you received $85,000 from customers and the boutiques. Your bow-making materials included ribbon, wire, glue and clips, which totaled $15,000.
Gross income = $85,000 - $15,000 = $60,000
Your operating expenses included web hosting at $300, cell phones for all three employees at $3,600, internet service at $600, new laptop at $1,500, new desk at $900, scissors and hot glue guns at $100, advertising at $1,000, accountant fees at $2,000, paying contractors at $10,000 and taxes at $7,800.
Total operating expenses = $27,800
Net income = $60,000 (gross income) - $27,800 (expenses) = $32,200
To operate a profitable business long-term, you may determine that you and your employees need to produce more bows, or you need to find a less-expensive ribbon supplier. Or, you might consider paying for more targeted online advertising than you did the year prior. A year where you purchase new office supplies like a computer and desk may be less profitable by offsetting some of your sales.
An awareness of these numbers helps you see how your business operates and if you are happy with the income or want to make any changes. Knowing your net income every year also helps you track trends in your business. You can analyze external factors, such as market trends, freelance employee availability or what kind of customers you have to make adjustments when needed.
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