Investors use net income as part of their investment decision into a company’s stock.
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What Is Net Income?
Net income is the amount of money left over from a company’s revenue after expenses and tax payments have been made in a period. It is a critical measure in understanding the financial strength of a business. Investors and analysts look at a company’s net income to determine its level of profitability. For example, net income relative to revenue—a metric known as net income margin or net profit margin—would indicate a company’s ability to generate profit. If expenses exceed revenue, that would be a net loss—or simply, a loss—for the period.
For the company’s executive management team, net income is helpful in determining areas in which to tweak its finances—whether to cut back on certain expenses such as cost of goods sold, salaries, and interest payments, or to ramp up production to boost revenue. It’s also helpful in understanding how to redistribute cash back to shareholders in the form of dividends.
For publicly traded companies, net income is found in the income statement portion of the financial statement filed quarterly and annually with the Securities and Exchange Commission. Net income is also called net profit, net earnings, or earnings. Just like revenue is referred to as the top line item on the income statement (before expenses are deducted), net income is the bottom line item (after all expenses have been deducted).
Net income is a measure under generally accepted accounting principles (GAAP). Terms that are related to net income but are non-GAAP include adjusted net income and EBIT because their calculations don’t follow accounting rules.
How to Calculate Net Income
The simplest way to calculate net income is to subtract all expenses and tax payments from a company’s revenue. But there are specific items along the way to deduct from revenue. The first item to take away is cost of goods sold, which leads to gross margin, or gross profit. Operating expenses are subtracted from gross profit, and the difference is operating income. Interest costs (or costs of debt financing) and tax payments are deducted from operating income, and that difference leads to net income.
Net Income = Revenue – Cost of Goods Sold – Operating Expenses – Interest Costs – Tax Payments
Net Income Formula
Net Income = Cost of Goods Sold – Operating Expenses – Interest Costs – Tax Payments
Net Income Example: Apple (NASDAQ: AAPL)
In the table above for Apple’s annual income statements from 2017 to 2021, the top line item for revenue is labeled net sales. Moving down on the income statement, items are deducted line after line, forming subtotals along the way, until reaching net income.
Some investors tend to focus on gross margin because it helps them understand the basic costs of production before additional expenses are deducted.
Some companies separate their net income into two types: net income attributable to the company, and net income attributable to common shareholders. Net income attributable to common shareholders is the true bottom line figure because the earnings exclude dividends paid to a separate class of stockholders.
Apple breaks down its net income into earnings per share, which is categorized by basic shares and diluted shares, and either figure is calculated by dividing net income by the number of common shares. Basic is the number of common shares outstanding, while the diluted figure is the preferred measure because it accounts securities that can be converted into common shares, such as stock options and convertible bonds.
In special cases, a company might include income that is not recurring, or is not included as part of the periodic reporting. This would be known as a non-recurring item, or an extraordinary (one-time) item, and would skew the net income figure. An extraordinary item on income or loss would be tied to the gain or loss from the sale or acquisition of an asset, for example.
How Is Net Income Used?
Net income can be used to redistribute cash to stockholders in the form of dividends or stock repurchases. Dividend investors tend to favor utilities stocks because they typically use much of their net income to pay dividends to shareholders, for example. Some companies might also use their earnings to buy back stock in the open market to boost earnings per share, on the expectation that it enhances shareholder value—the fewer shares in the open market, the higher the earnings on a per-share basis. The stock repurchases are then converted into treasury stock, which the company can use to issue employee stock options or resell later.
Any money left over and not distributed to stockholders becomes retained earnings, which are reported in the shareholders’ equity statement. Net income from the period can be transferred to retained earnings.
How to Interpret Net Income
Investors and analysts use net income to compare the profit of companies within the same industry. Profitability ratios such as net profit margin are popular metrics to evaluate a company’s ability to generate profit.
As seen in the table above, Apple’s earnings rose significantly in 2021 from the year before as sales of its products and services grew faster than its cost of sales. Its net income almost doubled within the 5-year span, from $48.4 billion in 2017 to $94.7 billion in 2021 as management successfully kept operating expenses under control.
How Does Net Income Affect the Balance Sheet?
Net income flows into shareholders’ equity in the form of retained earnings. Retained earnings includes earnings from previous periods and net income from the latest period, excluding dividends to be paid out.
What Is the Difference Between Net Income and Operating Cash Flow?
Net income serves as a measure of financial performance, while cash flow isn’t a measure of profitability. Cash flow keeps tracks of inflows of a company’s cash per period, and also helps to keep track of its checking account. Operating cash flow is calculated by adding the cash balance to cash inflows then subtracting cash outflows.
Cash Flow = Cash Balance + Cash Inflows – Cash Outflows
Operating Cash Flow Formula
Cash Flow = Cash Balance + Cash Inflows – Cash Outflows
Frequently Asked Questions (FAQ)
The following are answers to some of the most common questions investors ask about net income.
Can Net Income Be Higher Than Revenue?
Net income is lower than revenue because revenue is the top line item from which expenses are deducted. However, in rare instances, net income can be higher than revenue if extraordinary, or one-time, items are included in a period.
Can Net Income Be Negative?
Net income can be negative if expenses exceed revenue, and that figure would be called net loss, or simply, loss. Net income can also be zero.
Is Negative Net Income Bad?
Negative net income, or loss, for a period means that the company is unprofitable. But some investors and analysts may argue that for newly established companies, or startups, the degree of losses for a period or longer may be justified as money is being spent to grow its business.
What Is Considered Good Net Income?
That is subjective to the views of executive management, investors, and analysts. If the company is profitable, then it is positive on net income. Some startups have losses for quarters, or even years, before making a profit.
Is Net Income a GAAP Term?
Net income is a term used under generally accepted accounting principles.
What Is Net Income Per Share, or Earnings Per Share?
Earnings per share is calculated by dividing net income by the number of common shares outstanding.
