Business leaders use the phrase net income when referring to a company’s total profits – after they’ve taken all expenses into account. These expenses may include the production costs of products/services, taxes, fees, operational costs, etc.
Executives and entrepreneurs use net income as the basis for a vast array of calculations, estimates, and projections.
For example, investors, managers, creditors, etc. use net income figures to determine how efficiently companies make money. By understanding the ins-and-outs of this foundational concept, you can avoid costly miscalculations and misunderstandings – and create effective long-term strategies.
Businesspeople use the phrase net income when referring to the amount of revenue a company has left over after its expenses. However, this begs the basic question:
When we say “revenue,” we mean a company’s total receipts for a given period. This includes the actual amount of money (cash, checks, credit cards, etc.) a business takes in, regardless of returns, refunds, etc.
Revenue, a company’s “top line,” is the opposite of net income, the ever-popular “bottom line” (of a company’s income statement).
This phrase has entered common speech because net profit is the best way to examine profitability (though accounting terms may have vastly different meanings in common parlance and expert use).
Every kind of negative transaction, even the simple return of a defective product for another (hopefully working) one, counts as an expense. By tracking each-and-every expense (in each-and-every possible category) you can accurately examine your company’s health and profitability.
Put another way, revenue equals gross income, but not net income. Confused yet? Keep going – I’ll ease you through this.
Profit = Revenue - Expenses
In this simple case, net income equals profit. However, remember I’m referring to “net profit,” not one of the other profit types. (Scroll down to learn the differences between the three types of profit.)
Consider an example of net profit:
Net Income = Total Revenue - Total Expenses
Say you run an organic cat toothpaste company. This business brought in revenues of $80,000 this quarter, you don’t get to keep all that cash. You need to pay employees, buy raw materials, buy treats for the cats who test your product and pay the medical bills of people wounded by grumpy kitties who didn’t want their teeth brushed. Of course, you also need to pay taxes and maintain proper insurance.
Let’s say you add up all your expenses and they come to $100,000 for this quarter. Are you running a profitable business?
Net Income [-20,000] = Total Revenue [80,000] - Total Expenses [100,000]
It’s time to re-think and restructure your business. You’re in the red!
As I mentioned above, people often refer to net income as net profit or “the bottom line.” Net income and net profit mean the same thing – but many new businesspeople find this equivalency confusing. The trick is this: there are many kinds of profit, but only net profit equals income.
From another angle: net income equals net profit, but net income doesn’t equal profit, in general. For instance, a roma tomato is the same size as a kiwi fruit, but not all kinds of fruit. Surely, a watermelon dwarfs a roma tomato. In short, profit, like “fruit” is a general term, which can create confusion when we refer to it casually.
To communicate clearly with other businesspeople, always specify the kind of profit to which you’re referring.
The 3 Kinds Of Profit:
This simple, common sense formula helps you get a basic grasp on your company’s profitability:
Gross Profit = Net Sales - Cost of Goods and Services
Net Sales refers to sales of products and services – not income from the sale of investments and assets. Also, be sure to subtract discounts and allowances from this figure.
Your Cost of Goods and Services (COGS) includes the funds you directly spent on creating/developing your product or service. Lowering this amount can dramatically improve your bottom line (and get you “out of the red”).
For example, you may need to haggle with vendors and shop around to get the best prices on your raw products. In your organic cat toothpaste business, this would mean getting the best deals possible on vegetables and meats from your local farmers and sourcing your coconut oil (a firming agent in your toothpaste) in bulk quantities to lower your resource costs.
Take a look at the discounts and other marketing enticements you offer new customers. Do they match your anticipated growth figures? Are you spending too much? Too little? Are you offering discounts simply to shed excess inventory?
If you’re interested in calculating the true health of your business, examine your company’s operating profits with these two methods:
The idea is to separate the money you make via production and sales from all your company’s other financial activities. By subtracting your unrelated expenses, you can determine the success of your core functions: production, overhead, sales/marketing, wages/salaries, etc.
To get a business loan, you’ll need to provide operating profit numbers. Your lender will compare your Operating Profit Margin to the size of your business to determine your stability. You probably want a high margin for your niche business.
For example, if you sell very few cat toothpaste tubes at boutique prices, you can survive on a lower volume of sales. Only large, big-box retailers (with massive sales volume) can remain profitable on slim margins.
After setting aside all your company’s costs (interest, taxes, amortization, depreciation, etc.) from your net sales, you can finally determine your net profit/net income:
Net Profit/Net Income = Gross Profit - (Total Operating Expenses + Interest + Taxes + Amortization + Depreciation)
When someone asks you, “Is cat toothpaste really profitable? What’s your bottom line?” give them the figure you derived from the (rather large) formula above. Investors, vendors, and other stakeholders need this information to get a clear picture of your operational health.
That being said, most businesspeople understand startup businesses need time to reach profitability. An investor in your cat toothpaste company may well understand that you plan to lose money attracting customers in the first 2 years and make your profits in years 3-5.
This person might well take your customer base figures more to heart than your bottom line. As long as you’re on track to profitability and meet your targets, you can still attract the capital you need to get off the ground.
So, calculate net income, understand the various types of profit, and give your stakeholders the best possible information – trusting in your company’s continued sales and market share growth!
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