Net Income

Net Income: Definition in Accounting

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: SEC)}

How to Calculate Net Income (Step-by-Step)

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.

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 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.

The taxes owed to the government are based on the corporate tax rate and jurisdiction of the company among various 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.

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:

• Revenue Year-over-Year (YoY) Growth
• Gross Profit Margin (%)
• Operating Margin (%)
• Tax Rate (%)

Net Profit Margin Analysis: 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.

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.

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

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?

As a measure of profitability, the net profit metric can misleadingly portray a company’s financial well-being from a liquidity and solvency standpoint.

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)