The primary objective of any business is to be profitable. While there are many ways profitability is analyzed, net income remains a definitive indicator of how a business is doing.
In this FAQ we will discuss what net income is, why it is important, how to interpret it, and the basic function for calculating net income.
What Is Net Income?
Net income is an accounting concept that is a representation of all a business’s earnings less all expenses. It is sometimes referred to as the “bottom-line”. Because net income is an accounting concept, calculation can be impacted by changes in accounting policy.
Why Is Net Income Important?
Net income is a universal concept, meaning it applies both for a big business or an individual. Typically, analysts review net income to understand if the business is a valid going concern .
Going concern “is an accounting term for a company that is financially stable enough to meet its obligations and continue its business for the foreseeable future.”
Net income over time is monitored to identify if the business is becoming more efficient and growing its revenue base.
In addition, public companies use net income to calculate earnings per share and investors use it to identify expenses.
Interpreting Net Income
One of the limitations of net income is that it includes non-cash expenses like depreciation – allocating the cost of a tangible asset over its useful life and is used to account for declines in value over time. In addition, it includes amortization – used to periodically lower the book value of a loan or intangible asset over time.
Net income also includes all tax expenses for a period. This can be somewhat convoluted as businesses attempt to reduce net income as much as possible to avoid tax exposure.
In addition, a more relevant metric is EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). By relying on EBITDA in conjunction with Net Income, analysts can identify how well the business is at pumping out profit in its core business. EBITDA focuses on bare bones information, removing data that can make it harder to understand how profit is related to the core business. Essentially, it removes the noise [JM2] associated with accounting policies, tax exposure, and interest related to current financing agreements.
How To Calculate Net Income
Net income is calculated on the Income Statement. Individuals can calculate net income simply, by taking their net take-home pay and reducing it by their expenses. Businesses rely on a more complex calculation.
The calculation for computing net income can be best summarized using the standard approach to building an income statement. Detailed buckets help guide us through the calculation. An example is below:
Total Revenue $xx
Less: COGS $xx
Gross Profit $xx
Less: Operating Expenses $xx
Less: Depreciation Expense $xx
Less: Amortization Expense $xx
Less: Interest Expense $xx
Less: Tax Expense $xx
Net Income $xx
It is important to note that you can calculate EBIT or EBITDA using Net Income as a starting point. In this scenario, you would take net income and add back depreciation, amortization, interest, and tax expenses.
Calculating net income on a cash basis is typically more straightforward. The process accounts for all cash receipts as revenue and all cash expenses as operating expenses. Amortization and depreciation are ignored entirely as they are non-cash expenses.
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