What is Net Income?
Net Income is a profitability metric that measures the residual, after-tax earnings of a company once all operating and non-operating costs are deducted.
The net income profit metric, or “net earnings,” can be found at the bottom of the income statement and is calculated as revenue subtracted by all operating costs, such as cost of goods sold (COGS) and selling, general, and administrative (SG&A), as well as non-operating costs like interest expense and income taxes.
What is the Definition of Net Income?
The net income metric, i.e. the “bottom line” on the income statement, represents a company’s residual earnings, inclusive of all operating and non-operating expenses incurred in a given period.
In accounting, the net profit metric is the amount of revenue left over once all expenses have been accounted for, such as the following costs and expenses:
- Cost of Goods Sold (COGS) → The direct costs related to the company’s core operations generating revenue.
- Operating Expenses (OpEx) → The indirect costs related to company operations (e.g. selling, general and administrative)
- 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).
- 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.
The formal definition of “Net Income” per the Securities and Exchange Commission (SEC) is shown below.
Net Profit Definition (Source: US SEC Financial Reporting Manual (FRM))
How to Calculate Net Income?
The step-by-step process of calculating net income, written out by formula, is as follows:
- Step 1 → Gross Profit = Revenue – Cost of Goods Sold (COGS)
- Step 2 → Operating Income (EBIT) = Gross Profit – Operating Expenses (OpEx)
- Step 3 → Pre-Tax Income (EBT) = Operating Income (EBIT) – Interest, net
- Step 4 → Net Income = Pre-Tax Income (EBT) – Tax Expense
Starting from revenue, i.e. the “top line” of the income statement, we first deduct COGS to calculate the gross profit metric.
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).
EBIT represents the point on the income statement where all operating costs (i.e. COGS and OpEx) have been deducted, so all the costs onward are non-operating.
After those non-operating costs have been subtracted from EBIT, we’re left with the company’s pre-tax income or earnings before taxes (EBT), i.e. the taxable income of the company.
Once the company’s pre-tax income has been reduced by its tax expense, we’ve arrived at the company’s net income.
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.
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:
What is a Good Net Income?
By itself, net income as a standalone metric is not too meaningful. In order for a company’s after-tax earnings to become more practical and facilitate comparisons over different historical periods, as well as to its industry peers, the profit metric must be standardized.
How to Find Net Income on the 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.
Apple Income Statement (Source: Apple 2021 10-K)
Net Income vs. Cash Flow: What is the Difference?
For instance, a company could consistently produce positive net earnings yet 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 under 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 (LIFO vs. FIFO)
- EPS Increase from Share Repurchases (Treasury Stock)
- Debt % in Capital Structure (Leverage Ratio)
Net Income vs. EBIT vs. EBITDA: What is the Difference?
The fact that debt is factored into the net income line item through interest expense causes the metric to be less practical for peer comparisons.
Most of the metric’s limitations stem from the imperfections of accrual accounting that make net income prone to the risk of earnings management (i.e. manipulation of numbers) and a potentially misleading depiction of a company’s operations.
For that specific reason, the cash flow statement reconciles a company’s net earnings, i.e. the starting line item, adjusting for the actual cash inflows/(outflows) to assess the true cash impact from operations, investing, and financing activities.
How are Net Income and Retained Earnings Connected?
The “Retained Earnings” line item appears in the shareholders’ equity section of the balance sheet and represents the accumulated earnings kept by a company to date, net of any common and preferred dividends issued to shareholders.
The formula used to calculate retained earnings is as follows.
Net Income Calculator
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
1. Income Statement Historical Data (AAPL)
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)|
|Plus: Other Income / (Expense)||258|
Note: Apple’s financials are expressed in millions ($mms).
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 filed by Apple.
2. Net Income Calculation and Profit Margin Analysis
The net income reported on Apple’s income statement was $94,680 million, confirming the figure we arrived at was calculated correctly.
- Net Income, 2021A = $109,207 million – $14,527 million = $94,680 million
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%
In conclusion, the 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.