Net Income Formula: How to Calculate Net Income (+ Examples)
Net income is one of the most important metrics on an income statement. Calculating net income is a crucial part of doing business.
If you don’t know what your revenue is, you do not have a business. Knowing your revenue alone (gross income) does not accurately show your business financial performance.
In addition to knowing your gross income, you need to know whether your company made a profit after subtracting business expenses.
In this article, you will learn the differences between gross income and net income, the formula for calculating the net income in the income statement, the operating net income formula, and what net income can tell business owners.
Let’s get started.
Gross Income vs Net Income
Gross income and net income are two critical profitability metrics for any business. They are both found in the income statement.
Gross income for businesses refers to the total revenue a business makes minus the cost the business incurs to sell goods and services (cost of goods sold). For individuals, gross income is the total revenue or sales an individual makes. It is also referred to as gross profit.
Net income for businesses refers to the total revenue a business makes minus the cost of goods sold (COGS) and other business expenses not related to the sales process such as taxes including payroll tax, interest, administrative and operating expenses, and depreciation. Other names for net income are net earnings, net profit, or the company’s bottom line.
Gross income takes into consideration only sales-related expenses while the net income takes into consideration all expenses that a business incurs, including non-sales-related expenses.
Investors use the gross income to determine how much profit a company generates from producing and selling its goods and services. Net income helps investors to determine a company’s overall profitability.
Gross income assesses a company's ability to earn a profit while handling its labor and production costs while net income assesses a company’s ability to earn a profit from all aspects of its business operations.
The net income is more inclusive than the gross income and provides insight into the effectiveness of the company’s management. It is the net income that the business uses to pay shareholders, offset debts, invest in new projects or equipment, or save for future use.
Gross income is always more than the net income and it is not dependent on the net income, while the net income is always less than the gross income and it is dependent on the gross income.
Net Income Formula: Calculating Net Income on the Income Statement
Net income refers to the total profit a company makes after deducting all its business expenses. It is the most important metric used by investors, analysts, and shareholders to measure the profit the company earns over a period.
The net income formula can be calculated in several ways.
Net Income = Total Revenue – Cost of Goods Sold – Operating Expenses
If you leave out the operating expenses from the formula, what you have is the total revenue minus the cost of goods sold (COGS), which is the formula for calculating gross income.
The net income can also be calculated with this formula:
Net Income = Gross Income – Operating Expenses
You can also express the net income formula as:
Net Income = Total Revenues – Total Expenses
An extended formula for calculating the net income is:
Net Income = Total Revenue – (Cost of Goods Sold + Depreciation + Other Expenses)
Net income can either be negative or positive. You have a positive net income when your company generates more revenue than it spends (expenses). However, if your business’ total expenses exceed your revenue, you have a negative net income. Another name for the negative net income is a net loss.
Using any of the five net income formula variants listed above, you can find the net income of any company for any given period.
The result of your income statement calculation is your net income. You can find the net income figure at the bottom of the income statement.
Calculating the net income on the income statement is easy and requires just three steps. First, you gather all the sources of revenue for the business, record them on the income statement, and sum them up to get the total revenue.
Second, you gather and record all expenses related to the cost of goods sold (COGS) and then sum them up to get the total cost of sales. Third, you gather and record all other business expenses that are not related to the cost of goods sold (COGS) and then sum them up to determine the total other expenses.
Finding the net income on your income statement involves adding the total cost of sales and the total other expenses, and then deducting the result you got from the total revenue.
Net Income = Total Revenue – (Total Cost of Sales + Total Other Expenses)
Net Income Formula: An Example
Let’s assume Watts Thrift Shop, an online store hosted on the eCommerce platform Shopify, wants to find its net income for the first quarter of 2021. Here are the numbers available for us to work with to calculate the company’s net income for the period.
- Total Revenue – $50,000
- Cost of Goods Sold (COGS) – $10,000
- Rent – $3,000
- Utilities – $1,000
- Payroll – $5,000
- Advertising – $500
- Interest Expense – $500
- Tax – $1,500
The first thing to determine is what variant of the net income formula is suitable for these numbers.
Net Income = Gross Income – Operating Expenses – Tax
With this formula, the first thing to find out is the gross income.
Gross Income = Total Revenue – Cost of Goods Sold (COGS)
The total revenue is $50,000 while the cost of goods sold is $10,000.
Gross Income = $50,000 – $10,000
Gross Income = $40,000
Now that we know the gross income for Watts Thrift Shop, the next step is to add up its other expenses to complete the other part of the equation for the quarter.
Operating Expenses = Rent + Utilities + Payroll + Advertising + Interest Expense
Operating Expenses = $3,000 + $1,000 + $5,000 + $500 + $500
Operating Expenses = $10,000
Now that we have all the numbers we need to calculate the net income (gross income and expenses), let’s find out the net income for Watts Thrift Shop.
Net Income = Gross Income – Operating Expenses – Taxes
Net Income = $40,000 – $10,000 – $1,500
Net Income = $28,500
Watts Thrift Shop’s net income for the first quarter of 2021 is $28,500.
Operating Net Income Formula
The operating net income is another important metric that every business should track. Operating net income is similar to net income. It refers to the profitability of income-producing property or revenue less any operating expenses.
The operating net income formula looks at the company’s profit from operations alone, it excludes income and expenses that are not part or related to the company’s core activities.
Some of the income and expenses the operating net income excludes are interest expense, interest income, income tax, and gains or losses from sales of fixed assets.
Operating income is also referred to as EBIT which is an acronym for “earnings before interest and taxes.”
The formula for operating net income is:
Operating Net Income = Net Income + Interest Expense + Tax
Operating Net Income = Gross Profit – Operating Expenses – Depreciation – Amortization
Operating Net Income = Total Revenue – Direct Costs – Indirect Cost
The operating net income gives a clearer idea of how profitable the company’s core business activities are. Lenders and investors sometimes prefer to use the operating net income to gauge the profitability of a business instead of the net income.
For example, an internet service provider may be losing money on its core operations but if it sells a building it owns, the profit will be included in the company’s net income. Such a gain or profit may make the company feel like it is doing well but in reality, it is struggling to operate efficiently.
The operating net income takes out such gain so that investors, lenders, and internal management can get a clearer picture of the company’s profitability.
Example Calculation Using the Operating Net Income Formula
Let’s assume an accounting software wants to calculate its operating net income for the first quarter of 2021.
Operating Net Income = Gross Profit – Operating Expenses – Depreciation and Amortization
The accounting software has a gross profit or income of $100,000, operating expenses of $25,000 and depreciation and amortization of $1,000.
Operating Net Income = $100,000 – $25,000 – $1,000
Operating Net Income = $74,000
The operating net income for the accounting software is $74,000.
If we want to calculate the operating net income for Watts Thrift Shop, we know its net income is $30,000, its interest expense is $500, and taxes is $1,500.
Net Income + Interest Expense + Taxes = Operating Net Income
$30,000 + $500 + $1,500 = $30,500
The operating net income for Watts Thrift Shop is $32,000.
Calculating the net income and operating net income is easy if you have a good understanding of small business bookkeeping basics.
What Net Income Can Tell Business Owners
Net income is a crucial metric used to measure the profitability of a business. Business owners calculate the net income of their businesses because of the wealth of information it provides about the business.
1. Helps Business Owners Know If Their Business Is Profitable or Not
The first and foremost reason why business owners track their net income is to know whether their business is profitable or not. By adding up all incoming revenues and deducting them from all other expenses the business incurs, business owners can know if the business is generating profit or recording a loss.
For long-term business success, profitability is an essential metric every business owner should attain. The net income helps business owners know if their business is profitable or not.
2. Helps Business Owners Determine the Overall Health of Their Business
The net income is a useful metric for determining if a business is healthy or not. When a business is healthy, it means it has more assets than it has liabilities, and can comfortably pay its short-term liabilities without hurting its operations.
Net income is not a stand-alone metric, other factors such as one-time or large charges or investment windfall can impact it.
Business owners and investors can review the net income from time to time to determine if the business is increasing, decreasing, or maintaining the same level. They can compare the net income margins of other businesses to see how well their business is performing among their competitors.