What is net income? | Financial literacy

There are a lot of parameters to pay attention to when it comes to financial reporting. Few are as significant or as important as a company’s bottom line. This is the total income earned during a period (for example, a fiscal year) after deducting all expenses incurred during the same period. It is a figure reported on the company’s income statement and correlated to its profitability. Net income is most often referred to as the company’s bottom line or total profit.

Although it is presented as a static number in the company’s income statement, net profit is actually more useful as a rolling measure. Companies capable of making more money than they spend are profitable and therefore more efficient. The ability to increase bottom line and profitability over time signals a healthy business model. More importantly, this is a positive sign for investors looking for a lucrative place to park their capital.

How to calculate net income

Net income comes from subtracting the company’s total expenses from its total income. This includes expenses such as cost of goods sold (COGS), selling and administrative expenses, general expenses, operating expenses, depreciation of assets and other expenses. It also takes into account the cost of taxes. The formula for net income Is simple :

Net income = Total income – Total expenses

Simply put: net income is profit. It is the extent to which a business is able to exceed its expenses by generating income. The path to that profitability is evident on the company’s income statement, which shows the breakdown of numbers that attribute both income and expense to the equation.

Net earnings and earnings per share

Beyond a showcase of overall profitability, bottom line is an important variable in calculating a company’s earnings per share (EPS). Many investors use EPS as a measure of the company’s performance over the past period. Companies also tend to issue expected EPS: the amount that shareholders can expect stocks to appreciate over the coming period.

It is also important to consider Basic EPS vs diluted EPS. Diluted EPS is the measure of the company’s net income allocated among common shares, while taking into account dilutive events, including the exercise of employee stock options, warrants and convertible preferred shares. . Diluted EPS is almost always lower than basic EPS, but tends to give a more accurate picture of how the company’s bottom line benefits investors.

How businesses use net income

Net income is the money the business can use as it sees fit, since all business expenses are factored into its calculation. Depending on the financial health or stage of growth of the business, there are a number of things that it can choose to do with its profits:

  • Pay dividends. Public companies pay a dividend as a way to redistribute net income to shareholders. This dividend is used to pay out profits, which attracts more shareholders, bringing more investor capital to the company.
  • Retained earnings. Retained earnings are the earnings that the company chooses to keep after paying dividends, in order to increase its cash reserves. Many companies choose to keep profits when planning a known expense or when preparing financial reports, in order to strengthen the balance sheet.
  • Reinvest the profits. More often than not, companies choose to reinvest their net income in the business. This may include purchasing new equipment, expanding production facilities, adding new assets or making acquisitions.

How the business uses its profits can play an important role in how investors view it as an investment. The choice often comes down to the company’s forward-looking goals, its leadership philosophy and its upcoming financial obligations.

An example of net income at work

ABC Company recorded total sales of $ 2.5 million in 2020. The company recorded business expenses of $ 1.2 million and paid taxes of $ 300,000 during the same period. ABC Company’s net income in 2020 was $ 1 million.

ABC Company pays out $ 600,000 of this income as dividends to shareholders, resulting in $ 400,000 in retained earnings. Of these retained earnings, the company chooses to spend $ 100,000 on new production equipment and $ 150,000 on R&D initiatives for the coming year, putting the final $ 150,000 in the bank.

Investors looking at ABC Company’s financial data over the past three years will see net income growth: $ 900,000 in 2018, $ 1 million in 2019, and $ 1.2 million in 2020. This healthy growth, in addition to the way the company has managed its profits, indicates that ABC Company is a smart investment.

Important factors to consider

Like all financial measures, the net result is subject to a certain level of manipulation. It’s important for investors to look beyond the bottom line, to look at the factors that contribute to it. Do business expenses make sense? Does its turnover match the published sales figures? While financial reporting and auditing standards ensure a level of transparency in financial reporting, the burden of understanding them always falls on investors.

Businesses with Consistent Profits Succeed

Net income is synonymous with bottom line for a reason: because it is the ultimate goal of the company’s ability to make money. Companies that show constant net income from period to period will attract investors. Why? Because they continue to prove the effectiveness of their business model.

And these are the types of businesses you want to invest in when you retire. To learn more about smart investing and preparing for retirement, subscribe to Rich retirement e-letter below.

Companies that make money are able to return it to shareholders or reinvest it for even greater future profits. Whatever its use, the fact that the business is profitable matters above all.

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