For small business owners, understanding your numbers is vital. While there are several important metrics you can track, perhaps one of the most important numbers to pay attention to is net income.
What is net income?
Net income is the amount of profit your company has left over after paying all expenses.
The formula for calculating net income is:
Total revenues – total expenses = net income
In this equation, total revenue is the total amount earned from sales of products or services, as well as income from other sources, such as interest and gains or losses from sales of fixed assets. Total expenses include the cost of goods sold, operating expenses, depreciation and amortization, interest expense, taxes, and other costs. The cost of goods sold can be calculated by using the following formula: beginning inventory plus purchases minus ending inventory equals the cost of goods sold.
People often refer to net income as “the bottom line" because it appears at the bottom of an income statement. It may also be called “net profit" or “net earnings." Whatever term you use, they all refer to a company's profits that remain after subtracting business expenses from revenues.
When your net income is negative, it's called a net loss.
Why is net income important?
Net income is an important business metric because it represents the money left over that you can distribute to shareholders, invest back into the business, or save for future use.
Net income helps determine:
- Whether your business appeals to investors. Investors look at a company's net income when deciding whether to invest in the company. A company with a history of consistent net income is appealing to investors because they know they're more likely to receive a return on their investment.
- Whether you can get a small business loan. Banks and other lenders look at a company's net income when deciding whether they should approve a business loan or line of credit. Lenders are more willing to extend credit to companies with high net income because the company is more likely to pay the loan back.
- Whether your business is sustainable. Many small businesses generate net losses initially. But eventually, your business will need to generate revenues and control expenses to survive in the long term. Tracking your net income can help you understand whether you're charging enough for your products and services to cover the costs of running the business.
Net income vs. cash flow
It's also important for business owners to understand the difference between net income and cash flow. While net income represents a company's profits during the accounting period, cash flow represents the amount of cash that comes in or goes out of the business over the period.
It's possible to have a positive net income but have a negative cash flow. This can happen if you use the accrual accounting method and sell your products or services on credit.
For example, say you have sales of $100,000 during January and expenses of $75,000. Your net income for the month is $25,000. However, you only received $50,000 in cash from those sales in January. Your customers will pay the remaining $50,000 in February. Although your net income is positive, you have negative cash flow because $75,000 in cash went out to pay expenses while only $50,000 in cash came in from January's sales.
For that reason, lenders, investors and other stakeholders usually look at net income on your company's Profit & Loss Statement in tandem with your Statement of Cash Flows. The Statement of Cash Flows provides a picture of your business's actual cash position in addition to its profitability.
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