How to Calculate Net Income: Formula, Examples, and Step-by-Step Guide

Welcome to the ultimate guide to understanding net income, a crucial financial metric that speaks volumes about a business’s profitability! 

Luckily, doola Bookkeeping can give you a real-time view of your business’s financial health, showing your total revenue minus all expenses incurred in real-time — ultimately yielding net income.

Whether you’re an aspiring entrepreneur, a seasoned business owner, or just someone keen to enhance financial literacy, we can provide you with accurate financial insights that can drive your business forward.

In this blog, we’ll break down how to calculate net income, from simple formulas and practical examples to a crystal-clear step-by-step guide that demystifies the process. 

By the end of your reading journey, you’ll be empowered with the knowledge needed to assess fiscal health and make informed decisions like never before. 

Ready to unlock those secrets? Let’s dive in!

What Is Net Income? 

Net income is the total amount of money that remains after deducting all expenses and taxes from a company’s or individual’s revenue, representing the actual profit earned by them. It plays a crucial role in providing a comprehensive understanding of the financial performance of both businesses and individuals.

A high net income indicates that a company is generating substantial profits, while a low one may suggest inefficiency or losses.

For individuals, understanding their personal net income can help with budgeting and saving strategies. 

By knowing how much money they have left after covering necessary expenses and taxes, individuals can plan their spending accordingly and work towards building wealth for their future.

Why Net Income Matters for Small Businesses

First and foremost, net income depicts the amount of money left over for owners or shareholders after all expenses have been paid. A higher net income translates to more profits that can be reinvested into the business or distributed among stakeholders. 

On the other hand, a negative net income (also known as a loss) indicates that the business has spent more than it earned.

By comparing your current year’s net income to previous years or industry averages, you can gain insights into areas where costs may be too high, or revenues could be increased.

Furthermore, tracking net income on a regular basis allows you to make realistic projections and plan for growth or expansion within your means. This also comes in handy when seeking external funding, as lenders and investors often use it to check a company’s financial stability and potential return on investment.

Moreover, accurate financial statements provided by automated bookkeeping software can automate tax filings and help you avoid potential penalties from regulatory authorities.

Net Income Formula Explained

Understanding how to calculate net income is essential for individuals and businesses alike since it is the amount of money left over after deducting all expenses and taxes from total revenue. 

You can use this to pay shareholders, invest in new projects or equipment, pay off debts, or save for future use. The basic formula for calculating net income is:

Total Revenue – Cost of Goods Sold – Expenses = Net Income

When your company has more revenues than expenses, it has a positive net income. If its total expenses are more than its revenues, it has a negative net income, also known as a net loss.

Using the formula above, you can find your company’s net income for any given period: annual, quarterly, or monthly—whichever time-frame works for your business. This formula takes into account all sources of revenue, including sales, service fees, and interest earned. 

On the other hand, total expenses include the cost of goods sold (COGS), operating expenses such as salaries, rent, utilities, marketing costs, taxes paid to the government, and interest on any outstanding loans or debts.

Breakdown of Key Components

To gain a better understanding of how net income is calculated, let us break down the key components involved in the formula:

📈 Revenue

As mentioned earlier, revenue includes all sources of income generated by a business during a specific time period. It is generally reported on the top line of an income statement or profit & loss statement.

📈 Cost of Goods Sold (COGS)

This refers to the direct costs incurred in producing goods or providing services sold by a company. It typically includes material costs and labor expenses directly related to production activities but excludes indirect costs like overheads.

📈 Taxes

Every business must pay taxes on their profits earned during a given period. The amount of tax paid varies depending on the company’s location, size, and other factors.

📈 Operating Expenses

These are ongoing costs incurred by a business to keep its operations running smoothly. They can be fixed (e.g., rent) or variable (e.g., advertising expense). 

Some common examples of operating expenses are salaries/wages paid to employees, rent/utilities for office premises, and marketing/advertising costs.

📈 Interest

If a business has taken any loans or has outstanding debts, it will have to pay interest on them. This interest expense is deducted from total revenue to arrive at net income.

Step-by-Step Example: How to Calculate Net Income

Let’s say you own a small retail store and want to calculate your net income for the year ending December 31st, 2024. 

So, when you have gathered all the necessary financial information from your accounting records, including revenue, expenses, and taxes, you can start with the calculation.

Calculating Net Income As a Business

Step 1: Calculate Total Revenue

The first step is to calculate your total revenue or sales generated during the year. Let’s assume that your retail store had $500,000 in sales in 2024.

Step 2: Subtract Cost of Goods Sold (COGS)

Next, you need to subtract the cost of goods sold (COGS) from your total revenue. COGS includes all direct costs related to producing or purchasing goods sold by your business. 

For example, if it costs you $200,000 in inventory purchases and other direct expenses, such as freight and materials used to produce goods sold in 2024.

Calculating Total Revenue – COGS = Gross Profit ($500,000 – $200,000 = $300,0000) yields a gross profit of $300,000.

Step 3: Deduct Operating Expenses

Now, it’s time to deduct all operating expenses incurred during the year, such as rent, utilities, salaries and wages paid to employees, and advertising costs, which we assume is $120,000.

So, you can use the formula of Gross Profit – Operating Expenses = Earnings Before Interest & Taxes (EBIT).

$300,000 – ($10000 + $50,000 + $60,000) = $180,000 EBIT

Step 4: Calculate Interest and Taxes

Now, you have to subtract any loan interest payments and taxes due for the period from the EBIT. 

For example, let’s say you paid $20,000 in interest on your business loans and had a tax liability of $25,000.

So, you can calculate the Net Income by EBIT – Interest Expense – Taxes ($180,000 – $20,000 – $25,000 = $135,000 Net Income)

Congratulations! You have successfully calculated your net income for the year ending December 31st, 2024. 

This figure represents your profit after all expenses and taxes have been paid. This amount can be reinvested back into the business or distributed among shareholders as dividends.

Calculating Net Income for Personal Finance

For individuals who receive a regular paycheck from their employer, gross income is their annual salary plus any additional earnings from bonuses or commissions throughout the year. 

Net income is also known as “take-home pay” for individuals, which refers to the amount of money that remains after all relevant expenses have been deducted from gross income. 

These expenses can include taxes (federal, state, and local), social security contributions, retirement plan contributions, insurance premiums(medical/dental/life), union dues, charitable donations, and other deductions allowed by law.

To calculate the net income as an individual, you must deduct all of these expenses mentioned above from their gross income.

Let’s suppose a person earns $150,000 per year, and the following deductions apply:

• Taxes: $10,000

• Health insurance: $3000

• Retirement contributions: $2000

Net Income = $150,000 – $10,000 – $3000 – $2000 = $135,000

The individual’s net income is $135,000, which is the actual amount available for spending and saving.

Gross Income vs. Net Income: What’s the Difference? 

Knowing the difference between gross income and net income is crucial for accurately assessing one’s financial standing. It allows both individuals and businesses to make informed decisions about their finances and plan accordingly for future expenses.

While both relate to income, there are significant differences that can impact an individual’s or business’s financial situation in various ways.

Gross income refers to the total amount of money earned by an individual or business before deductions. 

On the other hand, net income refers to the amount remaining after all relevant expenses have been deducted from gross income. 

In some cases, gross income may seem like a large figure, but it can often be misleading, as it does not take into account necessary expenses such as taxes and healthcare costs. 

Net income provides a more accurate representation of an individual’s or business’s actual earning potential. It is also used to calculate one’s debt-to-income ratio, which is a crucial factor in determining eligibility for loans or mortgages. 

Having a high percentage of net income going towards debt payments can impact credit scores and make it challenging to obtain future financing.

Operating Income vs. Net Income: What You Need to Know

When it comes to understanding a company’s financial health, 2 key metrics that often get confused are operating income and net income. While both of these figures can provide insight into a company’s profitability, they represent different aspects of the overall financial picture. 

Operating income is the profit a company generates from its core operations before accounting for other expenses, such as taxes and interest. 

Net Income + Interest Expense + Taxes = Operating Income

This figure represents how much money a company earns, specifically from its primary business activities.

On the other hand, net income provides a more comprehensive view of a company’s profitability as it considers all sources of income, not just those related to operations.

The main difference between operating income and net income lies in the inclusion or exclusion of non-operating items such as interest, taxes, gains, or losses on investments or assets. These items can significantly impact the bottom line but may not be directly related to a business’s day-to-day operations.

For example, let’s say your company has an operating revenue of $500,000 but also incurred interest expenses for loans totaling $50,000. 

Its operating income would be $450,000 ($500K—$50K). However, after accounting for taxes amounting to $20K and additional gains on investments worth $10K during that period, its net income would be only $440K ($450K—$20K + $10K).

While both operating income and net income provide valuable information about a company’s financial performance, they represent different aspects and should not be used interchangeably.

How to Report Net Income on Financial Statements

The first step in reporting net income on financial statements is to use the income statement or balance sheet. 

An income statement summarizes a company’s revenues and expenses for a specific period, typically quarterly or annually. It is usually listed as the last line item on the income statement, while it appears as retained earnings on the balance sheet.

So, the first step in reporting net income is to determine which financial statement it will be included in — the income statement or the balance sheet. 

The income statement reports revenues and expenses for a specific period, whereas the balance sheet income includes all the gains or losses from assets and liabilities. 

Next, you must determine the time period since net income should be reported for a specific period, usually an accounting year or quarter. This allows stakeholders to track the performance of a company over time and make informed decisions accordingly.

By following these steps, businesses can ensure that their net income is accurately reflected in their financial records, which provides valuable insights for decision-making.

Instead of tracking all transactions and doing manual calculations, you can use doola Bookkeeping for accurate financial statements, making it easier and more efficient for businesses to track their net income accurately.

Common Mistakes When Calculating Net Income

Many people often make common mistakes when calculating net income, which can have serious repercussions on their financial planning and decision-making. 

By understanding these potential pitfalls, you can confidently calculate your net income and get better insights into your financial situation.

❌ Forgetting to Include All Sources of Income

One common mistake people make when calculating net income is only considering their primary source of income, such as their salary or business profits. 

However, it is crucial to account for all sources of income, including interest earned from investments, rental property income, and any other supplemental income.

❌ Failing to Deduct All Expenses

Another mistake that can significantly impact the accuracy of net income calculation is not deducting all relevant expenses. 

So, you must carefully review all expenses related to generating the reported revenues and consider them while calculating net income.

❌ Incorrectly Categorizing Expenses

Expenses should be correctly categorized as either fixed or variable for accurate net income calculation. Fixed costs do not change with changes in production or sales volume, while variable costs fluctuate based on these factors.

❌ Overlooking Tax Deductions

Tax deductions can significantly reduce your taxable income and hence impact your overall net income calculation. Make sure you are aware of potential tax deductions that you may qualify for and include them in your calculations.

❌ Not Accounting for Non-cash Transactions

Non-cash transactions, such as depreciation or amortization, do not involve an actual outflow of cash.

However, they affect the overall profitability and should be accurately accounted for when calculating net income.

Master Net Income Calculation With doola Bookkeeping

Manually calculating net income can be time-consuming and prone to human error. That’s why doola Bookkeeping software is designed to automate this process, making it easier for businesses to manage their finances.

With doola, you no longer have to spend hours poring over spreadsheets or worry about miscalculations in your net income figure. 

Firstly, our software helps you track your revenue accurately by automatically linking it to your bank accounts and credit card transactions, eliminating any chance of errors or omissions in recording your earnings.

In addition to providing an accurate overall net income figure, doola also breaks down the components of your expenses, giving you valuable insights into which areas contribute most significantly to your overhead costs.

Next, doola makes it easy to categorize expenses and keep track of them using our expense tracking feature.  Plus, our flexible pricing plans makes it accessible for businesses of all sizes.

Moreover, our team of expert bookkeepers can help you maintain accurate financial records and provide you with valuable insights to make informed decisions for future growth and success. 

Book a demo today and take control of your finances like a pro!