How to Calculate Net Income and Its Impact on the Balance Sheet

While many people might assume net income is directly found on a balance sheet, it is primarily calculated on a different financial statement: the income statement. This article will explain where net income is determined and then demonstrate how this figure ultimately influences a company’s financial position, as reflected on its balance sheet.

The Income Statement

The income statement is a financial report that summarizes a company’s financial performance over a specific period, such as a quarter or a full year. Its main purpose is to show whether a business made a profit or incurred a loss during that time. It details how revenues are transformed into net income after all expenses are considered.

Key components include revenue (sales), Cost of Goods Sold (COGS), operating expenses, non-operating income and expenses, and income tax expense. Revenue represents the total money a company earns from its primary operations. COGS are the direct costs associated with producing goods or services. Operating expenses cover the day-to-day costs of running the business.

Calculating Net Income

Calculating net income begins with a company’s revenue. Revenue is the total money generated from sales of goods or services before any costs are deducted. From this, Cost of Goods Sold (COGS) is subtracted to determine gross profit. COGS includes direct costs like raw materials, direct labor, and manufacturing overhead.

Once gross profit is established, operating expenses are deducted to arrive at operating income. These expenses, often called selling, general, and administrative (SG&A) expenses, are the indirect costs of running the business, not directly tied to production. Examples include rent, utilities, marketing, and administrative salaries. Operating income reflects the profit from core business operations before considering interest and taxes.

Following operating income, non-operating income and expenses are accounted for. These are revenues or costs not directly related to the company’s main business activities, such as interest income from investments or interest expense on loans. Adding non-operating income and subtracting non-operating expenses from operating income yields income before taxes.

The final step involves subtracting income tax expense from income before taxes. The resulting figure, after all revenues are recognized and all expenses, including taxes, are deducted, is the net income, often referred to as the “bottom line” or net profit.

The Balance Sheet

The balance sheet provides a snapshot of a company’s financial position at a single point in time. Unlike the income statement, which covers a period, the balance sheet shows what a company owns, what it owes, and the value invested by its owners on a particular date. This statement is built upon the fundamental accounting equation: Assets = Liabilities + Owner’s Equity.

Assets represent economic resources controlled by the company that are expected to provide future economic benefits. Common examples include cash, accounts receivable (money owed to the company by customers), inventory, and property, plant, and equipment. Liabilities are obligations a company owes to outside parties, representing future sacrifices of economic benefits. These include accounts payable (money the company owes to suppliers), salaries payable, and loans payable.

Owner’s Equity, also known as shareholders’ equity for corporations, represents the residual interest in the assets after deducting liabilities. This section generally includes components like common stock, which is capital directly invested by shareholders, and retained earnings, which represent accumulated profits kept within the business.

Connecting Net Income to the Balance Sheet

Net income, while calculated on the income statement, has a direct impact on the balance sheet, specifically within the owner’s equity section. The profit or loss generated over an accounting period directly flows into the equity account called Retained Earnings. Retained earnings represent the cumulative portion of a company’s net income that has been kept within the business since its inception, rather than being distributed to shareholders as dividends.

When a company generates positive net income, this profit increases its retained earnings. Conversely, a net loss would decrease retained earnings. The calculation for ending retained earnings for a period is: Beginning Retained Earnings + Net Income – Dividends Declared = Ending Retained Earnings.

Dividends are distributions of a company’s earnings to its shareholders, and they reduce the retained earnings balance. Therefore, a company’s decision to reinvest profits back into the business or distribute them to shareholders directly affects the growth of its retained earnings.

Illustrative Example

To demonstrate the flow from calculating net income to its impact on the balance sheet, consider a hypothetical company, “GreenTech Solutions,” for the year ended December 31, 2024. GreenTech Solutions generated $500,000 in revenue from its sales of eco-friendly products. The direct costs associated with producing these products, or Cost of Goods Sold (COGS), amounted to $200,000. Subtracting COGS from revenue yields a gross profit of $300,000.

Next, GreenTech incurred operating expenses such as salaries, rent, and marketing, totaling $150,000. When these operating expenses are deducted from the gross profit, the company’s operating income is $150,000. GreenTech also had some non-operating income, such as interest earned on a savings account, amounting to $5,000, and non-operating expenses, like interest paid on a small business loan, totaling $10,000. This brings the income before taxes to $145,000 ($150,000 + $5,000 – $10,000).

Assuming a federal corporate income tax rate of 21%, GreenTech’s income tax expense would be $30,450 (21% of $145,000). Subtracting this tax expense from income before taxes results in a net income of $114,550 for the year. This net income figure, derived from the income statement, now impacts GreenTech’s balance sheet.

On GreenTech’s balance sheet, suppose the beginning retained earnings balance as of January 1, 2024, was $50,000. During the year, the company decided not to declare any dividends to its shareholders. Therefore, applying the retained earnings formula (Beginning Retained Earnings + Net Income – Dividends Declared = Ending Retained Earnings), the ending retained earnings for GreenTech Solutions on December 31, 2024, would be $50,000 + $114,550 – $0 = $164,550. This increase in retained earnings directly enhances the owner’s equity section of the balance sheet, reflecting the company’s profitable operations during the period.