Your small ecommerce business is selling branded items such as coffee mugs and tote bags with company or event logos for corporate conferences, golf tournaments, and investment seminars. You started the business more than a year ago and have been handling much of the finances on the fly.
Now you need to do some serious accounting, starting with your sales receipts and a complete rundown of your costs. It all starts with knowing how to calculate your business's net income.
Total revenue - total expenses = net income
Here's the step-by-step process to calculate net income:
- Calculate total revenue from all sources
- Calculate total expenses including cost of goods sold, operating expenses, interest, and taxes
- Subtract total expenses from total revenue
For example: If your business generates $100,000 in revenue and has $75,000 in total expenses, your net income equals $25,000.
In this article, we'll walk you through what net income is and how to calculate it using this simple formula.
Shortcuts
What is net income?
Net income equals total revenue minus total expenses, operating costs, and taxes. Net income is the most important reference point for the financial health of a business, large or small. Sometimes it's referred to as profit, earnings, or the bottom line, because it's at the end of a formal income statement, which sometimes is known as a profit and loss statement.
Business owners use net income to review sources of revenue and expenses, to compare net income across different time periods, and to consider changes such as boosting sales, cutting costs, expanding, and hiring. Net income is what owners can use to pay themselves, while lenders and investors examine a business's net income—along with other measures of performance—in deciding to extend loans or invest in the business.
What is included in net income?
Unlike some other measures of financial performance—such as earnings before interest, depreciation, and amortization (EBITDA)—net income includes all revenue and all expenses. It's important that a business track all expenses. Failing to do so may require inclusion of overlooked expenses in the future, resulting in a financial restatement. This can damage a business's credibility. An accurate bottom line is essential.
Revenue can come from several sources:
- Sales. Sales of goods and services typically account for most of a small business's revenue.
- Rental income. This can come from property or other assets, such as leased machinery.
- Assets. Property and other assets generate revenue when sold.
- Interest. Bank accounts, bonds, some stocks, and other financial investments that pay interest income.
Sales are listed as the first, most important source of revenue. Other revenue items are sometimes called non-operating revenue, and usually appear on income statements below product and services sales. Total revenue is calculated by adding sales and any non-operating revenue.
Expenses are typically listed in this order on an income statement:
- Cost of goods sold (COGS). Cost of goods sold includes expenses for raw materials and production labor. These are called variable costs, because they tend to increase or decrease based on production volume.
- Operating expenses. These costs, sometimes called fixed expenses or overhead, usually don't fluctuate with production levels. These include office rent, salaries, utilities, and maintenance.
- Interest expense. This includes expenses to repay loans or credit lines.
- Taxes. All businesses pay federal income tax, as well as state or local taxes, depending on where the business is based.
- Other expenses. These include depreciation and amortization. Depreciation is for the estimated loss in value of a business's fixed assets, also called tangible assets, such as production equipment and machinery. Amortization is for intangible assets such as patents, trademarks, and trade names. Some software and website development costs may qualify as intangible assets as well.
How to calculate net income
The formula for net income is:
Total revenue - total expenses = net income
The calculation process involves these intermediate steps. First, you calculate gross income by subtracting cost of goods sold from total revenue. Next, you determine operating income by subtracting operating expenses from gross income. Finally, you subtract interest expense and taxes to arrive at net income.
Here's how this calculation works for the hypothetical ecommerce company that sells branded items. The business bought printing and engraving equipment last year for $2 million using a bank loan at a 7% annual rate. The annual net income calculation results in:
| Revenue | |
| Sales of products | $5,000,000 |
| Interest income from invested cash | 5,000 |
| Total revenue | 5,005,000 |
| Cost of goods sold | -3,500,000 |
| Gross income | 1,505,000 |
| Selling, general & administrative expenses | |
| Rent | -300,000 |
| Utilities | -40,000 |
| Phone/computer/WiFi | -45,000 |
| Payroll | -120,000 |
| Marketing/advertising | -50,000 |
| Office supplies | -20,000 |
| Depreciation, equipment | -400,000 |
| Operating income | 530,000 |
| Interest on $2 million loan | -140,000 |
| Taxes | -125,000 |
| Net income | $265,000 |
In addition to calculating net income, business owners usually gauge profitability by expressing their net income as a percentage of total revenue. This is called the net profit margin or net income margin. The basic formula for this calculation is:
Net income / Revenue = Profit margin
In the case of the hypothetical ecommerce company, the net profit margin is:
$265,000 / $5,005,000 = 0.0529 or 5.3%
How to calculate net income FAQ
What is the formula for calculating net income?
The basic net income formula is:
Total revenue - total expenses = net income
Is net income calculated after tax?
Yes, net income is always an after-tax figure. Businesses sometimes report other measures of profitability before net income, but those exclude some expenses. These metrics include earnings before taxes (EBT), earnings before interest and taxes (EBIT), and earnings before interest, taxes, depreciation, and amortization (EBITDA). These are sometimes used to gauge a business's operational performance, especially among startups with lots of debt or companies with large investments in equipment or real estate.
What is not included in net income?
Nothing is excluded from net income. That is why it's called the bottom line, because it leaves nothing out of the calculation.
Can businesses have negative net income?
Yes. Negative net income means a business is operating at a net loss, with expenses exceeding revenue. When this happens, a business can look for ways to boost revenue or reduce expenses to reach profitability. Businesses with long-term net losses often don't survive.
