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What is net income and why is it important?

What is net income and why is it important?

Whether you are a sole trader doing your own accounting, or thinking about becoming an accountant, understanding the financial terms of your business account is essential.

Net income, sometimes called net profit, is one of the most important calculations to get right for several reasons.

It is part of calculating profit and loss statements, and it shows what money the business has made, after all deductions such as taxes, cost of goods, and overheads have been accounted for.

This article will touch on what net income is, how to calculate it, and why it is important.

Here’s what it covers:

What is net income?

Net income is a figure that is calculated to tell you how much your business has made after expenses, cost of goods, and tax has been taken, for a particular period of time.

You should understand your net income amount because it helps you keep tabs on the available money your business has or flag any debt you might accrue. Unlike the gross profit amount, it shows the real take home earnings of the business.

The net income amount can be positive or negative so it will either show a profit, or a loss.

As an employee, you hope net income is never in the negative, but as a business owner, it’s not the end of the world, as some months you may need to spend more on expenses than the business makes.

If a negative net income continues month-on-month. however, this should set alarm bells ringing and spur you to take immediate action.

Net income is also commonly referred to as net profit and net expenses. To find out more differences between what is net profit and net income, read the glossary entry.

Net income definition

How do you define net income?

Net income is your company’s total profits (whatever money is left) after deducting all costs of operation.

Costs of operations include business expenses such as inventory, insurance, salary payouts, rent, equipment costs, advertising, miscellaneous expenses—anything that you’ve paid in service of your business.

Also included in the costs of operating a business are depreciation, loss on investments, and payable taxes.

For example, if your business sold £10,000 worth of goods in a month, but spent £4,000 on product, £1,000 on advertising, £1,900 on tax, and £350 to a contractor, you would use your formula, or software that calculated it for you, to discover the net income for that month which is earnings, minus the other expenditures.

In this simple example, your net profit/income would be £2,750.

How to calculate net profit or net income

Net profit = Total revenue – (Expenses + Tax)

The simple net income definition is your company’s net profits or net earnings.

Commonly used to determine the profitability of individual sections or a business as a whole, factoring net income is an important evaluative measure for any business.

Why is net profit important?

Understanding net profit and net income is important because this figure shows the financial health of your business.

It will also inform your business strategy and the immediate future prospects of your company.

For example, if your net income is in the negative for several years, that means your business isn’t profitable.

You may not get investors you need to expand, and you will have to work hard to turn the business around into profitability.

But if a business is making positive net profits month-on-month, you might be able to finally expand a product line you’ve been wanting to create, or get funding from investors you’ve been trying to impress.

Final thoughts

Understanding these key terms will help you manage your business finances more effectively.

Working with an accountant or accounting software that can calculate these figures automatically will also free up your time to spend doing more strategic planning for business success.