What is net income?
Net income is the total profit that an organisation generates after all its costs have been subtracted. The figure outlines the financial viability and success of a business.
Net income differs from total or gross income, which is the sum of all revenue coming into the business. It also differs from net profit, which only considers income and expenses directly related to business activities and does not account for items like depreciation or tax payments.
Net income can be calculated for any period of time you choose. Monthly, quarterly and annual calculations are commonly used by businesses. However, you can tailor your calculation to what may be more relevant to your industry and not necessarily for a specific time period. For example, you can tally net income by project, such as an end-of-season sale or from a particular client.
Generally, net income is the funds currently held by the business and does not include any upcoming or outstanding payments or expenses. While it may be rare to not be paid for a product or service, it is not unheard of and may result in a loss being recorded in your accounts instead of the expected income. To maintain an accurate net income, only record expenses as they are paid, not when they are anticipated.
How to calculate net income
To determine the net income, you first need to understand where your money is coming in and where it is going out of your business.
Depending on the size of the business, using a complex accounting system may not be necessary to keep track of expenses and revenue. Some organisations may rely on business software to add and subtract their gains and spending. Others, such as sole traders, may find a simple spreadsheet or accounting book is all that they require. To accurately keep track of expenses and revenue, however, every transaction needs to be recorded in the accounting system that is being used.
The mathematical formula (Total Revenue – Expenses = Net Income) represents how you can calculate net income. Add up all revenue and from this amount, subtract the sum of your expenses.
Calculating net income also will reveal if the business is in debt, known as a net loss. This occurs when total expenses exceed total income.
Sources of income
For most businesses, income is from one or two sources – selling goods and/or providing services.
However, there are other sources of income to consider when calculating your net income. These may include:
- interest on investments, including bank accounts
- rent, such as leasing office space or hiring out equipment
- the sale of assets
- licensing content to third parties
- royalties
Each type of income may not occur regularly, so it is important to record incoming funds in the accounting system as soon they are paid to avoid overlooking them. For example, a monthly interest payment is less likely to be forgotten than a one-off sale of plant or equipment.
Sources of expenses
There are myriad sources of expenses, so it can be easy to overlook one. However, by making a note of the expense as soon as it occurs, it can be easier to keep track of it.
Sources of expenses include:
- employee salaries, penalty rates, leave loading payments and superannuation
- taxes
- depreciating assets
- office supplies, ranging from printer ink to tea bags
- advertising and marketing costs
Some expenses can be business tax deductions that may lead to a tax refund. But listing them as an expense, at least initially, helps prevent errors from being made or remove any doubt.
Reasons to keep track of net income
Aside from being used to compile a profit and loss statement for the organisation, it can be handy to know your net income to better handle day-to-day operations as well as conduct long-term planning.
Expand operations
A succession of solid net income results can provide the cash flow to expand operations. When saved, these funds can enable you to hire more staff, establish a new product line or trial a new service that can potentially further boost net income in the future.
Re-invest in your business
An understanding of what your net income is will enable you to make decisions to re-invest in existing business operations, too. For example, it may be a financial indicator of your workforce’s productivity and capability, enabling you to provide them with a pay rise or a bonus that will continue to keep them engaged and working productively.
Being aware of your net income also can help you to plan upgrades or replacement of equipment or to relocate to larger business premises, which may be able to occur more quickly than was previously planned if the value is larger than expected or be delayed if it was smaller.
Plan shutdowns or temporary workforce increases
Keeping tabs on net income month-to-month can identify financial patterns that can enable you to better plan shutdowns or annual leave. For example, if net income is lower every December – or even falls to a net loss – it may be financially prudent to organise a shutdown for that time of the year. This involves temporarily closing the business and allowing all staff to take annual leave. While little-to-no income may be generated during this time, costs also may be lower than if the business remains open.
Likewise, it can showcase times when hiring temporary staff may be a good idea to boost income even further. For example, an ice cream shop with higher net income in summer might consider to open earlier and close later than it does in winter to increase sales, which may require hiring additional employees.
Also remember to keep track of other annual events like Easter or industry-specific times, such as the end of the financial year. Aim to maximise business opportunities at times when net income peaks and minimise activity when net income falls.
What to do when a net loss occurs
While a net loss is concerning for any business owner, it may not be a disastrous result. An unexpected expense, such as purchasing new equipment, or a rare problem, such as an employee resigning, can be reasons for a temporary net loss. Saving a portion of previous surpluses can help to cover for a year or month when these unusual circumstances occur.
However, if a net loss occurs regularly, it may be a sign that you need to make significant changes to return your business to profitability. It may be wise to seek the advice of a business finance or development consultant in this instance.
Understanding what net income is will allow you to make an easy calculation that provides insight into the financial viability of your business operations. From there, you can use this information to make key decisions that will only improve your business going forward.
