An income statement highlights a business's performance. Tabulating both revenue and expenses, the numbers on this sheet form a solid base to evaluate past strategies and prepare the next set of actions and contingency plans.
Subtracting revenue from expenses spotlights the business's profit or loss position. This is where net income and operating income come into play.
While both of these metrics calculate a business's profit value, they express it in different ways. Let's discuss each of them.
Net income, also termed net earnings or net profit, is your company's profit value after deducing business expenses. It is also addressed as a company's 'bottom line', as it is calculated at the end of the income statement.
The formula for net income is:
Net Income = Revenue - Cost of Goods Sold - Business Expenses
Gross income equals revenue minus the cost of goods sold. This identity re-expresses the net income formula as:
Net Income = Gross Income - Business Expenses
To simplify further, net income is:
Net Income = Total Revenue - Total Expenses
This formula calculates the net income (positive or negative) in three different timelines - quarterly, monthly, or annually. Select the framework that best aligns with your business plans.
Shantel Johnson, aged 35, owns an advertising agency, SJohnson World, in Louisiana, New Orleans. She launched her business in January 2021 and wants to calculate her quarterly net income until March 2021.
Let's examine her launch numbers:
SJohnson World earned $50,000 in revenue for their services sold.
The agency paid:
- $18,000 in cost of services sold
- $3,500 in office rent
- $4,000 in utilities (electricity, water, snacks, sodas, etc.)
- $4,000 in business advertisements
- $600 in staff salary
- $4,500 in taxes
On the flip side, the agency earned $3,000 as interest income.
To calculate the agency's net income for its first quarter, Shantel must first calculate the net income formula terms individually.
Total Revenue = Revenue from Sale + Interest Income = 50000 + 3000 = $53,000
Total Expenses = Sum of All Expenses = 18000 + 3500 + 4000 + 4000 + 600 + 4500 = $34,600
Net Income = Total Revenue - Total Expenses = 53000 - 34600 = $18,400
Shantel's impressive net income highlights that her agency launched successfully!
One can calculate net income calculations manually both on paper and in Microsoft Excel. Let's decode an example to understand the Excel calculation more closely.
Jevonte Williams, aged 32, owns a dance studio in Downtown Detroit, Michigan. His studio is open to everybody. Yet, he makes special efforts to encourage participation from the marginalized groups of society. His vision is clear, "Equality promotes Creativity."
Williams' agency earned $65,000 in total revenue.
- $20,000 in cost of goods and services sold
- $3,500 in staff salary
- $5,000 in rent and utilities
He paid $5,000 as an interest expense on his business loan, $8,000 in taxes, and incurred a depreciation cost of $2,500.
Jevonte's net income can be calculated in Excel as follows:
As explained in the spreadsheet above, net income is arrived at by subtracting total revenue from total expenses.
While the ideology of both methods is the same, the math involved in calculating total revenue and expenses metrics varies slightly from the previous example.
Net income is one of the most looked after numbers in an income statement. It is a vital financial metric that holds principal value across spectrums.
It also affects company-related factors. For example, net income is a starting point to determine the share of dividends to distribute amongst shareholders.
There is no 'industry specified' benchmark that companies should try to achieve here. The number is customized, varying from company to company and industry to industry.
A high net income indicates the company is making praise-worthy profits, holds strong liquidity, and instills and reinforces investor trust that the company will repay shareholder dividends and other financial liabilities.
Conversely, a negative or low net income may call for investors to take cautious calls, resulting in reduced share valuations.
However, net income does not represent the actual cash earned by your business model. It is possible to manipulate these calculations. This failure to project the real health of the organization can cost you a significant loss of money and reputation in the industry.
Operating income, operating profit, or Earnings Before Interest and Tax (EBIT) focuses on a company's daily and core activities to calculate its profit position.
This financial metric accurately represents a company's overall health, assisting senior leaders, analysts, and investors with numbers that map solid strategies for the future.
The calculation excludes expenses not directly related to core business activities, income tax values, interest expense and income earned, and noncurrent items like cash paid for lawsuits and the sale of fixed assets.
The formulas for operating income are:
- Operating Net Income = Net Income + Interest Expense + Taxes
- Operating Net Income = Gross Profit - Operating Expenses - Depreciation - Amortization
Operating net income is a constructive metric to promote healthy professional discussions, especially during raising equity and company buy-outs. The transparency connects people, builds relationships, and fosters fruitful relationships.
Carrying forward Jevonte's example, he can add his interest payment and taxes to the net income value to calculate his studio's operating income.
Operating Income = Net Income + Interest Payment + Taxes = $21,000 + $5,000 + $8,000 = $34,000
Since the method and justification supporting net income and operating net income calculations are different, they affect an entrepreneur's professional lens to view and examine their business decisions.
For example, your business incurred consistent losses in the COVID-19 pandemic for six months in 2020. To offset this loss, you took a business call to sell an expensive inventory.
This sale was then included under net income calculations, misinterpreting that your company was afloat in the challenging economic period.
However, your operating income excluded this sale. This exclusion painted a clear picture of your company's poor working situation last year, giving you loopholes to focus and fix on!
While both net income and operating net income calculations have ramifications in shaping your business's financial health, the method you choose depends on your action plan to reach your mission and vision statements.
Ideally, operating net income sprays a more raw picture of the company, providing detailed insights that serve as a base for devising power-packed strategies to offset temporary pitfalls.
This being said, the net income formula holds its ground when evaluating profit numbers after considering all business aspects.
As a creative business owner, it's necessary to safeguard your time and energy into expanding your vision. Handling accounts is a time-consuming and, honestly, productivity-hampering exercise.
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