Net income
Net Income is sometimes referred to as the "bottom line" of the income statement. It is what remains after all costs and expenses have been subtracted from revenues (or sales). Net income is the result after subtracting tax expenses, cost of goods sold, selling, general and administrative expenses, depreciation expenses, and customer allowances, as well as extraordinary items (gains or losses).
Net income is sometimes contrasted with operating income (net income from normal operations only, not reflecting extraordinary/non-operating gains and losses). Net income is synonymous with net earnings, as well as net profit (if positive) or net loss (if negative).
The income statement is a financial statement that reports a company's income for a period of time, usually for a fiscal quarter or fiscal year. Income is thus a measure of the company's earning performance for a specific period. The income statement heading will so indicate with a phrase such as
- ". . . for the year ended 31 December 2011," or
- ". . . for the quarter ended 31 June 2011."
This contrasts with the balance sheet, which shows the status of assets, liabilities and owner’s equities at one point in time.
Note that income is also called "profits," "earnings," or, less formally "the bottom line," referring to its usual position on the income statement. However, "profit" refers to a company's overall net profit (the bottom line), but also to "gross profit" and "operating profit" (see the example statement below and the section Three Kinds of Profits below.). In any case, also note that many people refer to the income statement as a "profit and loss" statement, or "P&L"
• A Company Objective and Public Performance Measure.
• Income Statement Example
• Three Kinds of Profit (Three Margins)
• Income and Financial Statement Metrics
A Company Objective and a Public Performance Measure
Publically traded companies (those that sell shares of stock to the public) are required almost everywhere to report publically on financial performance and financial position, quarterly and annually. Privately held companies, however, may withhold such information from the public, from competitors, and from securities regulators (but not from tax authorities).
In principle, profit making companies exist and operate primarily to create value for their owners. The company's primary way of doing this is by earning income. Once income is declared there are essentially only two things the company can do with it:
- Declare all or part of the income as "retained earnings," which increases owner value by increasing owner's equity on the balance sheet.
- Distribute all or part of the income to the company owners (shareholders) as dividends—a more direct way to provide owner value.
The income statement generally shows how income figures result by subtracting the entity’s costs and expenses from its total sales revenues.
Income = All Revenues - All expenses and costs
Note by the way, that reported income, revenues, and expenses do not necessarily represent real cash inflows or outflows. This is because regulatory groups, standards boards, and tax authorities, allow or require companies to use conventions such as depreciation expense, allocated costs, and accrual accounting on the income statement. Actual cash flow gains and losses for the period are reported more directly on another reporting instrument, the Statement of Changes in Financial Position (or cash flow statement).
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Income Statement Example
The income statement is simply a detailed application of the income equation: Income = All Revenues – All expenses and costs. The example statement below might represent a manufacturing company, but the general form and major categories are typical for companies across a wide range of industries. A company that sells services rather than manufactured goods might report "Cost of services" rather than "Cost of goods sold," but aside from a few such minor differences in terms, the income statement structure is nearly universal.
Grande Corporation Gross sales revenues.................33,329 Gross profit.................................10,940 Operating expenses Operating income before taxes............... 3,130 Financial revenue & expenses Income before tax & extraordinary items..... 2,737 Extraordinary items Net Income (Profit).......................... 2,126 |
Notice that expenses fall into five major categories. The first three categories represent expenses that come from the company's normal business:
• Cost of Goods Sold
The costs of producing goods or services
• Operating Expenses – Selling Expenses
The costs of selling the goods or services
• Operating Expenses – General and Administrative Expenses
Overhead, support, and management costs from across the company
Note that depreciation expenses may appear in each of these categories, depending on what the assets in question are used for.
The remaining two major expense categories refer to both gains and losses from activities that are not in the company's normal line of business. This company is not, for instance, in the financial services, or financial investing, or lending business. The company is also not in the real estate business. Financial transactions in these latter areas must be reported separately from the areas that contribute to normal operating income.
• Financial Revenues and Expenses
These include revenues from invested funds and costs from financing
borrowed funds.
• Extraordinary Items
These may include large gains or losses from selling land or major assets,
or from major actions restructuring the company (e.g., the expenses of laying off
part of the workforce).
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Three Kinds of Profits (Three Margins)
Bottom line net income is a measure of the company's financial performance for the period, but the income statement contains other performance metrics as well. The difference between net sales revenues and cost of goods sold is called Gross profits, for instance, while the net income from operations—before taxes and before gains and losses from financial and extraordinary items—is called operating income (or operating profits).
All three of the profit lines from the income statement (gross profit, operating profit, and bottom line net profit) can also be expressed as a percentage of net sales, that is, as margins. Gross profit, for instance is gross profit divided by net sales (see the table below):
Margins, in turn, are very important indicators of a company's performance for stock market analysts, and for the company's own management.
- Analysts will compare the company's margin percentages directly with margins from competitors and with industry "best in class" standards. They will consider not only the current margins, but also period-to-period trends in margins.
- The company's management attention will focus on margins for several reasons:
- First, margins are central to the company's business model. Margin's in the model, that is, show exactly where the company expects to make money.
- Secondly, management will watch closely year-to-year changes in margins. Margins are a highly sensitive indicator of the company's ability to compete effectively and reach objectives in its business plan.
- Thirdly, Margins for individual product lines and even individual products are central to management planning and decision making in product portfolio management and other aspects of product planning. The income statement shows the gross margin, for instance, of the whole company, but underneath the company average gross margin (and shielded from competitors and public eyes), each product has its own gross margin as well. Only by knowing and managing the mix of individual product gross margins, can management optimize the overall product set gross margin.
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Income and Financial Statement Metrics
The term Financial Metrics refers to analyses performed on financial statement figures, as well as cash flow estimates in the business case and investment analysis. The word metrics means "measurement," and financial metrics—like descriptive statistics—reveal characteristics of a body of data that might not be appreciated easily simply by reviewing the data figures. Several of the major line items on the income statement provide further indicators of company performance, but contributing to commonly used Financial Statement metrics.
The financial statement metric (or "ratio") "Inventory Turns," for instance, is a measure of the company's ability to use assets efficiently and effectively. The metric is derived from an income statement term ("net sales") and a balance sheet term ("inventories"), and has meaning based on the idea that a company's assets should be working for the company and not sitting idle and unproductive.
Financial metrics based on financial statement figures are designed specifically to address questions like these:
- Is the company prepared to meet its short term financial obligations? Liquidity metrics such as current ratio address questions of that kind.
- Is the company using its resources efficiently?
Activity metrics such as inventory turns are designed for such questions. - Are the company's funds supplied primarily by owners or by creditors? Leverage metrics, such as debt to asset ratio provide answers.
- Is the company profitable? Is it making good use of its assets?
Profitability metrics such as the operating margin address such questions. - What are the company's prospects for future earnings?
Valuation metrics, e.g., price to earnings ratio deal with such questions. - How does the company's growth over the last five years compare to similar companies? To industry averages? Growth metrics such as the cumulative average growth rate (CAGR) for sales
revenues are useful for such questions.
Many of the input data items for these metrics come from the income statement. For a complete coverage of financial metrics, and of the interrelationships between income statement and balance sheet, and other financial statements, see the Solution Matrix Ltd. spreadsheet-based tool, Financial Metrics Pro.
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