How to Calculate Net Income for a Business
Go beyond top-line revenue to understand true profitability. This guide provides a clear method for calculating your business's bottom-line net income.
Net income represents a company’s total profit after subtracting all business expenses from its total revenues. Often called the “bottom line,” it appears at the end of an income statement and serves as an indicator of financial health. This figure shows how much money remains to pay shareholders, reinvest in the business, or pay down debt. Understanding this metric provides insight into a company’s profitability and operational efficiency.
Identifying Total Revenue
Total revenue is the starting point for calculating net income and represents all income a business generates from its primary activities, such as the sale of goods or services. Other income sources, like interest earned or gains from asset sales, also contribute to the total revenue figure. The timing of when revenue is recorded is governed by the accounting method a business uses.
Under the accrual basis of accounting, revenue is recognized when it is earned, regardless of when the cash is actually received. For example, if a service is completed in December but the client pays in January, the revenue is recorded in December. Conversely, the cash basis of accounting recognizes revenue only when payment is received.
Categorizing Business Expenses
Cost of Goods Sold (COGS)
The Cost of Goods Sold (COGS) includes all direct costs associated with producing the goods a company sells. These costs can include raw materials and the direct labor for workers who assemble the products. For a retail business, COGS is primarily the wholesale cost of merchandise purchased for resale.
These direct costs are separated from other expenses because they are directly linked to the products sold. Without incurring these specific costs, the product could not be created or acquired for sale. This category does not include indirect costs like marketing or administrative salaries.
Operating Expenses
Operating expenses are the costs a business incurs to support its day-to-day operations that are not directly tied to producing goods or services. These are grouped as Selling, General & Administrative (SG&A) expenses. Common examples include:
- Rent for office space
- Utilities like electricity and internet
- Salaries for administrative and sales staff
- Marketing and advertising costs
These expenditures are necessary for the business to function, even though they do not form a physical part of the final product. These costs are subtracted from a company’s gross profit to determine its operating income, which reveals the profit a business makes from its core activities.
Interest and Taxes
Interest expense represents the cost of borrowing money from lenders, such as on business loans or lines of credit. It is considered a non-operating expense because it relates to the company’s financing decisions rather than its primary business operations. This expense is deducted after operating income has been calculated to arrive at earnings before tax (EBT).
Income tax is the final expense deducted before arriving at net income and is calculated based on a company’s EBT. The tax rate can vary based on the business’s legal structure, as corporations pay a flat federal rate while pass-through entities report the income on the owners’ personal tax returns.
Step-by-Step Calculation Guide
The calculation of net income begins with total revenue. From this amount, the Cost of Goods Sold (COGS) is subtracted to find the company’s gross profit, which reflects the profitability of its products. For instance, if a business has $200,000 in total revenue and its COGS is $80,000, its gross profit is $120,000.
The next step involves subtracting all operating expenses from the gross profit. Continuing the example, if the business has operating expenses totaling $50,000, this amount is subtracted from the $120,000 gross profit. This leaves an operating income of $70,000, which shows the profit from core business operations.
Following the calculation of operating income, non-operating expenses, such as interest on loans, are deducted. If the business in the example has an interest expense of $5,000, this is subtracted from the operating income. The resulting figure, $65,000 in this case, is the earnings before tax (EBT).
The final step is to calculate and subtract the income tax expense from EBT. If the company’s income tax expense is $13,650, this is subtracted from the EBT of $65,000. The final result is a net income of $51,350, representing the company’s total profit.