On a company’s financial statement, also called its profit and loss statement, you’ll find net income near the bottom. Net income is a critically important metric that investors must understand to understand a company’s profitability.
What is net income?
In simple terms, a company’s net income is revenue minus all expenses. Starting with total revenue, follow these steps to calculate net income:
- Subtract the cost of goods sold or COGS: These are the direct costs associated with producing and delivering products and services that have already been sold. This yields gross profit. Gross profit as a percentage of revenue is the gross margin.
- Subtract operating expenses: These include costs associated with sales, marketing, research and development, administrative functions, and other areas that support the business. Operating expenses include one-time costs, such as restructuring charges and inventory write-downs. This yields operating income. Operating income as a percentage of revenue is the operating margin.
- Subtract interest expenses: A company in debt, whether through bank loans or outstanding bonds, will generally have to pay interest on that debt.
- Subtract other miscellaneous expenses: This can include various items, which vary from company to company. This yields pre-tax income.
- Subtract income tax expense: When a company produces a positive pre-tax income, it is generally required to pay income taxes. This yields net income or net profit. Net income as a percentage of revenue is the net profit margin.
Understanding net income
When someone talks about a company’s ‘bottom line’, they’re usually talking about net income. A positive net income tells you that a company has turned a profit; a negative net income, or net loss, indicates that a company is unprofitable.
Net income is an accounting figure. Companies generally use accrual accounting, under which payments and expenses appear when earned or incurred. A payment that a company receives is only counted as revenue when that company actually delivers the product or service, not when the payment hits the company’s bank account.
Expenses are treated the same way. For example, the COGS associated with an item is only recorded when sold, regardless of whether payment has been received, not when it’s produced. COGS also includes non-cash expenses such as depreciation, while operating expenses include non-cash expenses such as stock-based compensation.
Net income can be volatile
While it would be nice if the net income of every stock in your portfolio rose each year without fail, that’s unlikely to be the case. Net income is the result of subtracting a large number (total expenses) from another large number (total revenue). A small change in either can lead to a massive difference in net income.
A piece of the puzzle
Net income is a useful and essential profitability metric, but it’s not the only one. For example, it does not represent the amount of cash a company generates.
To fully understand a company’s profitability, pairing net income with free cash flow is your best bet. Net income is found on the income statement; free cash flow is on the cash flow statement. Free cash flow measures a company’s cash generated through operating activities in a given period.
Another thing to note about net income is that it can sometimes be a poor representation of profitability. One example: Generally accepted accounting principles, or GAAP, require that unrealised gains and losses on equity investments be recognised in calculating net income. Suppose a company owns a substantial stock portfolio, swings in the portfolio’s value influence net income and can distort the company’s profitability.