What is net income?
Net income, or net profit, is one of the single most important business metrics.
Why? Positive net income is a sign of growth.
It means you have extra cash flow left over after paying all necessary expenses to reinvest in that growth or to put away for emergencies or an upcoming slow season.
It means your business has the necessary breathing room to be flexible and handle changes, a necessary quality for long-term business survival.
So then, how do you calculate your own net income to see where your business stands?
In the next several sections, we’ll cover:
- What is the formula for net income?
- Why is net income important?
- Net income loss formula example
- Additional small business finance resources
What is the formula for net income?
The net operating income formula, sometimes referred to as the net income loss formula (same thing, don’t be confused!), is pretty straightforward.
To calculate net income, you simply subtract total expenses from total revenue:
Keep in mind that it can get a bit more complicated than that depending on how you calculate it, though net income is only ever the difference between total expense and revenue.
For example, COGS (cost of goods sold) is often subtracted first from total revenue to calculate gross profit:
Then operating expenses like salary, rent, utilities, depreciation, and amortization are subtracted to get your operating profit:
Thirdly, subtract interest expense and tax payments to arrive at total expenses:
Once you’ve got that, subtract total expenses from your operating profit to get your net income:
That’s all there is to it! You’ve used the net operating income formula to calculate your net income!
Why is net income important?
We touched on why net income is important, but it’s important to understand the full picture.
What is net income used for? Why would you need or want to know your net income, aside from the obvious knowledge in terms of cushion savings and how much you have to reinvest if that’s the route you’re going?
First, net income is an important metric if you’re looking for investors. It’s one of the single most important metrics investors look at to assess the future prospects of your business because it’s a sign of growth. It also means you have the profit to pay them dividends.
Similarly, net income is also an important metric in assessing the overall health of your business, so it’s one of the main metrics that creditors and lenders look at when qualifying you for financing. Creditors want to see that you have the necessary cash to pay back a potential loan in the event that they approve you.
And in terms of internal importance, net income tells you whether you’re in a position to pay your expenses with the revenue you’re making or if you’re at a net negative cash flow.
On the flip side, a low net income can tell you whether there’s a problem with your financial model, whether your expenses are too high, profit margins are too low, or some other issue.
Now, let’s dive into an example using the net income formula to help you better understand how it works:
Net income formula example
Jonathan is the owner of a commercial car dealership that sells work vans and other vehicles for local business owners.
He has an annual revenue of $925,000 with roughly a <50% COGS due to the cost of the vehicles he finances from his lender:
He pays himself a $115,000 salary and has a somewhat high depreciation resulting from the few vehicles he doesn’t sell for the previous year:
Tax and interest expense for the year from his vehicle financing plan combined equal $195,000:
Taken together, his operating profit of $244,000 minus total expenses of $195,000 equals $49,000:
Net income can be a bit confusing to calculate, given that you subtract COGS and operating expenses from revenue before getting operating profit, the number that’s technically considered “total revenue”.
However, with this kind of break down it makes the calculation pretty straightforward.
*Still seem a bit complicated? Click here to download a copy of our Microsoft Excel Net Income Calculator to run your own net income calculations.
Understand the net income formula? Now check out these other small business finance resources…
Net income formula is just one important calculation you need to run to get a handle on your small business finances.
To learn more about other important formulas, as well as other important business metrics, check out our guides:
- How to Calculate Gross Profit Formula
- Profit Margin Formula: How to Calculate Profit Margin and Tips for Improving Your Margin
- How To Calculate an Amortization Schedule
- What Is Debt-Service Coverage Ratio or DSCR?
- Looking for How To Calculate Ebitda? The Ebitda Formula Explained
- How to Create a Balance Sheet
