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Net Income

Step-by-Step Guide to Understanding Net Income in Accounting (Net Profit After Taxes)

Last Updated April 21, 2024

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Net Income

What is the Definition of Net Income?

The net income metric, or the “bottom line” on the income statement, is a company’s residual earnings, inclusive of all operating and non-operating expenses incurred in a given period.

In accordance with accrual accounting reporting standards, the net income metric is the revenue left over once all operating and non-operating costs have been accounted for.

The operating costs refer to cost of goods sold (COGS) and operating expenses (SG&A).

  • Cost of Goods Sold (COGS) → The direct costs incurred that pertain to a company’s core operating activities that generate revenue.
  • Operating Expenses (OpEx) → The indirect costs incurred that are necessary, yet not part of a company’s revenue model (e.g. SG&A expense, R&D expense)

On the other hand, non-operating costs include expenses that are not part of the core operations of a company.

  • Non-Operating Costs, net → The expenses unrelated to the company’s core operations – net of any non-operating income (e.g. marketable securities, short-term investments).
  • Income Taxes → The local, state, and federal taxes owed and paid to the government.

Since each line item above net profit, such as revenue and expenses, is recorded under accrual accounting standards, net income is also considered a measure of the “accounting profits” of a company.

How to Calculate Net Income

The step-by-step process to calculate net income, written out sequentially, is as follows:

Starting from revenue, i.e. the “top line” of the income statement, we first deduct COGS to calculate the gross profit metric.

Gross Profit = Revenue Cost of Goods Sold (COGS)

From the gross profit line item, we subtract operating expenses (Opex), resulting in the company’s operating income or earnings before interest and taxes (EBIT).

Operating Income (EBIT) = Gross Profit Operating Expenses (Opex)

Operating income (EBIT) represents the point on the income statement where all operating costs have been deducted. Therefore, all costs recognized on the income statement onward are non-operating items.

  • Operating Costs → Cost of Goods Sold (COGS) and Operating Expenses (or SG&A)
  • Non-Operating Costs → Interest Expense, One-Time Charges (e.g. Restructuring Charges, Write-Offs or Write-Downs).

The most common examples of non-operating costs are interest expense, net, and any one-time expenses, such as restructuring charges and write-offs (or write-downs).

After non-operating costs have been subtracted from EBIT, we are left with the company’s pre-tax income or earnings before taxes (EBT).

The pre-tax income (EBT) is the taxable income of the company.

Pre-Tax Income (EBT) = Operating Income (EBIT) Interest, net

The taxes owed to the government are based on the corporate tax rate and jurisdiction of the company, among other factors (e.g. net operating losses or “NOLs”).

Once the company’s pre-tax income has been reduced by its tax expense, we’ve arrived at the company’s net income (the “bottom line”).

Net Income = Pre-Tax Income (EBT) Tax Expense

Net Income Formula

The calculation of a company’s net profit is equal to its pre-tax income, or earnings before taxes (EBT), minus its tax expenses.

Net Income = Earnings Before Taxes (EBT) Taxes

For forecasting purposes when building a financial model, the net profit line item should NOT be explicitly projected, but rather, the line item is a function of the operating assumptions, most notably:

  • Revenue Year-over-Year (YoY) Growth = (Ending Net Revenue ÷ Beginning Net Revenue) – 1
  • Gross Profit Margin (%) = Gross Profit ÷ Net Revenue
  • Operating Margin (%) = Operating Profit ÷ Net Revenue
  • EBT Margin (%) = Pre-Tax Income (EBT) ÷ Net Revenue
  • Effective Tax Rate (%) = Income Taxes ÷ Pre-Tax Income (EBT)

How to Find Net Income on Income Statement

As we can see from the screenshot of Apple’s 2021 income statement, the beginning line item is revenue, and after deducting all operating and non-operating expenses, the ending line item is net income.

Right below the net profit line item, we can also see a separate section where the earnings per share (EPS) are calculated on a basic and diluted basis.

Net Income Apple

Apple Income Statement (Source: Apple 2021 10-K)

What is a Good Net Income?

By itself, net income as a standalone metric is not too meaningful. For a company’s after-tax earnings to become practical and facilitate comparisons across historical periods, including relative to its industry peers, the profit metric must be standardized.

A company’s net profits in a given period can be divided by the amount of revenue generated to calculate the net profit margin, a frequently used profitability metric among equity shareholders.

Net Profit Margin (%) = Net Income ÷ Revenue

A net profit margin in excess of 10% is perceived as “good” in most cases.

But to reiterate, the industry in which the company operates sets the “benchmark” to determine if a company is more profitable (or less profitable) relative to its peers.

Learn More → Net Margin by Sector (Source: Damodaran)

Net Income vs. Cash Flow: What is the Difference?

The net income of a company can be a misleadingly measure of profitability and portrayal of its current financial state from a liquidity and solvency standpoint.

The reason? While accrual accounting has become the standardized guidelines for financial reporting, the system remains flawed.

For instance, a company could consistently produce positive net earnings, but struggle to collect cash payments for sales made on credit – i.e. accounts receivable (A/R).

Despite not actually having retrieved the payment from customers, the sale is recognized as revenue on the income statement per accrual accounting.

Another issue is that discretionary corporate decisions can greatly affect a company’s net profits. Some of the more impactful discretionary management decisions are as follows:

  • Useful Life Assumptions for PP&E (Depreciation Expense)
  • Inventory Recognition Policies (FIFO vs. LIFO)
  • Increase in Earnings Per Share (EPS) from Stock Buybacks (or Share Repurchases)
  • Percentage of Debt in Capital Structure (Leverage Ratio)

Net Income vs. EBIT vs. EBITDA: What is the Difference?

  • Levered Metric (Post-Interest) ➝ The fact that the cost of debt is factored into the net income line item through interest expense causes the metric to be less practical for peer comparisons, i.e. levered measure of profitability (post-interest).
  • Unlevered Metric (Capital Structure Neutral) ➝ Compared to other non-levered metrics like operating income (EBIT) and EBITDA, net profit is used far less often in relative valuation, i.e. unlevered measure of profitability (pre-interest).
  • Shortcomings of Accrual Accounting ➝ Most of the limitations of net income stem from the imperfections of accrual accounting, causing the metric to be prone to the risk of earnings management (i.e. manipulation of figures) and a potentially misleading portrayal of a company’s real financial state.
  • Cash Flow Statement (CFS) ➝ The cash flow statement (CFS) reconciles a company’s net income – i.e. the starting line item on the financial statement – to adjust for the actual cash inflows / (outflows) to determine the true cash impact from operations, investing, and financing activities.

How is Net Income Connected to the Balance Sheet?

The connection between net income on the income statement and the balance sheet is retained earnings, or the accumulated accounting profits of a company since inception.

The formula used to calculate retained earnings is the prior period balance plus net income, subtracted by any issuances of dividends.

Retained Earnings = Prior Retained Earnings Balance + Net Income Dividends

The “Retained Earnings” line item is recorded in the shareholders’ equity section of the balance sheet and captures the accumulated earnings kept by a company to date, net of any common and preferred dividends issued to shareholders.

Net Income Calculator

We’ll now move on to a modeling exercise, which you can access by filling out the form below.

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1. Income Statement Historical Data

Suppose we’re tasked with calculating the net income of Apple (Nasdaq: AAPL) for the fiscal year ending 2021.

Using the figures from our earlier section, we’ll list the inputs below with the proper formatting, where the hard-coded numbers are entered in blue font, and calculations are left in black font.

Apple (AAPL) Income Statement 2021A
($ in millions)
Net Sales $365,817
Less: COGS (212,981)
Gross Profit $152,836
Less: R&D (21,914)
Less: SG&A (21,973)
EBIT $108,949
Plus: Other Income / (Expense) 258
EBT $109,207
Less: Taxes (14,527)
Net Income $94,680

Note: Apple’s financials are expressed in millions ($mm).

In Excel, we’ll compute each profit metric using the historical data points of Apple in fiscal year 2021.

As a general financial modeling “best practice,” we recommend confirming each calculation is correct by cross-checking between 1) the bolded figures in the table (i.e. the black font in the financial model) and 2) the actual income statement filing of Apple.

2. Net Income Calculation Example

The net income reported on Apple’s income statement was $94,680 million, confirming that the figure we arrived at was correctly calculated.

  • Net Income, 2021A = $109,207 million – $14,527 million = $94,680 million

Net Income Calculation Example

3. Net Profit Margin Calculation Example

Since the net income value by itself does not offer much insight into Apple’s profitability, we’ll calculate the net profit margin by dividing net income by revenue.

  • Net Profit Margin (%) = $94,680 million ÷ $365,817 million = 0.259, or 25.9%

The 25.9% net profit margin of Apple (AAPL) – which is the company’s standardized net income – can now be compared to its historical periods or to its comparable peers to analyze its current profitability.

Net Income Calculator

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