What is net income?
Net income is the income a company earns from sales and other gains after the deduction of all expenses, interests and taxes for an accounting period.
The expenditures comprise selling, general and administrative expenses (also known as SG&A), cost of goods sold (COGS), depreciation and amortization (D&A), operating expenses, etc.
Net income is also called net profit and net earnings. As it is filed at the end of the company’s income statement, is also termed as the ‘bottom line’.
The formula for calculating net income is:
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Negative net income reflects the loss that a company has incurred in a given period of time, and it happens when the total expenses of the said company exceeds its total revenue.
Where does net income appear in the three financial statements?
Net income is an important accounting metric as it is a central line item in all three financial statements.
The cash flow statement is started with the net income or loss in the indirect method. Further additions and subtractions for non-cash revenue and expense items are done to find out the results of the operating activities’ cash flow.
In the company’s balance sheet, net income is reflected under retained earnings, impacting shareholder’s equity.
Why is net income important?
Frequently Asked Questions (FAQs)
Operating income is the income a company generates from business operations after deducting variable and fixed operating expenses. It can be termed as operating profit as well.
In simpler terms, it is the profit a business earns from its core operations.
The formula to calculate operating income is:
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It is important to note that a company can earn huge profits from its operations but still report a net loss for the fiscal year. As a result, to evaluate the profitability, a company is suggested to evaluate each metric, such as gross profit, operating profit, EBITDA, etc. to understand the overall performance.
Suppose a company earns US$ 80 million operating profit and includes a significant amount of debt in its balance sheet. The interest charged on this debt is US$ 100 million. In that case, the income statement shows the loss of US$ 20 million despite having an operating profit of US$ 80 million.
The financial ratios which include net income as part of their calculations are:
It is part of a profitability ratio providing the final picture of how a company performs after bearing all the expenses. One drawback of this ratio is that it includes a lot of ‘noise’, like one-time expenses and gains, making it difficult to compare.
Net Income/ (1 - Dividend Payout)
A high return on equity ratio shows a company is competent in generating cash internally. As a result, the company becomes less dependent on borrowings.
It is a profitability ratio, showing how well a company can generate profits from its assets.
Net income reflects a business’ profitability, and a higher net income does not show high liquidity.
On the contrary, a company’s cash flow statement, which signifies its cash inflow and outflow, summarizes how it manages its cash position and funds its operations. Therefore, a company’s financial performance is more closely related to its cash flow than its net income.
A company’s cash flow statement does not reflect its profitability. Its function is to show how much cash is being spent and earned in a particular accounting period by a company.
A few scenarios where a company can report a positive cash flow along with a negative net income is as follows: