Have you ever wondered why some investors earn profits in the stock market while others incur losses? It is a common myth that the stock market is risky to such a level that it has a high potential for losses. However, if you base your investments on extensive research on companies and the market, chances are you can make good profits while avoiding high losses.
When it comes to analysing companies and the overall market trends, technical and fundamental indicators come into play. Within the fundamental analysis process, there are numerous metrics you can choose to gauge a company’s profit-making potential, allowing you to predict the stock’s future direction.
One such important metric is net income. This article will help you learn what is net income and how its understanding can help you make successful investments.
Read More: Accrued income
Understanding net income
Net income is a financial metric that showcases a company's net profit or net earnings in a quarter or a financial year. Net income is the amount that remains as profits or earnings after deducting various direct and indirect expenses from gross income.
The concept of net income can be attributed to both individuals and businesses. In the case of individuals, net income is the amount that remains after they have incurred all the expenses. In other words, it is the amount that an individual has saved. On the other hand, net income indicates a company’s efficiency in managing its business to ensure its expenses are lower than its overall revenue. The higher a company's net income, the more attractive it becomes to investors.
Read more: Active income
Types of net income
Now that you have understood what net income is, the next step is to learn about its types. Net income is categorised into two types: net income for businesses and net income for individuals.
Net income for businesses
Net income for businesses is also called the ‘bottom line’, as the net earnings header is at the bottom of a company’s income statement. Net income is also an important calculation for publicly traded companies to calculate their earnings per share (another financial ratio).
Companies earn revenue based on the sale of their goods and services but have numerous expenses, such as employee salaries, rent, debt repayment, etc. However, they operate their businesses to ensure they are left with profits after covering all the expenses. The revenue they earn is called gross income and becomes net income after deducting all the mandatory expenses.
Current shareholders and potential investors extensively examine the net income listed in the income statement to understand the company's ability to make profits. A higher net income increases the valuation of a company’s shares.
Here are the expenses that are deducted from the gross income to determine the net income:
- Operating expenses
- Cost of goods sold
- Taxes
- Dividends on preferred stocks
- Interest
Net income for individuals
Individuals who earn also have net income. It is the final income they are left with after paying for certain expenses and repaying their debt obligation, such as a loan EMI. Net income helps to ascertain how much liquidity a person has and how much savings is left after the end of a specific period.
Here are the expenses and obligations subtracted from an individual’s earnings to calculate net income:
- Legal obligations
- Loan EMIs
- Insurance policy premium
- Taxes
- Child support
- Contribution towards a retirement account
Net income calculation with example
There are three methods to calculate net income:
Formula 1: Revenue-cost of goods sold - expenses
Formula 2: Gross income - expenses
Formula 3: Total revenue - total expenses
Here is a table with revenue and expenses for a company listed in its income statement:
| Particulars | Amount (in Rs.) |
| Total revenue | 50,000 |
| Cost of goods sold | 10,000 |
| Rent | 5,000 |
| Utilities | 3,000 |
| Advertising | 7,000 |
Using formula 2, we can compute net income as:
Rs. (50,000-10,000) - 5,000 - 3,000 - 7,000 = 25,000
So, net income = Rs. 25,000
Read more: Types of shares
Significance of net income
The main significance of net income is for investors to analyse if a company is making adequate money. If it is, the company’s stock may be an ideal investment option. It also helps business owners assess their business and ensure they have a positive net income.
It is also an important metric for lenders to understand if a company that has applied to borrow funds has the ability to repay the loan amount. Furthermore, a positive and increased net income is beneficial for the company's goodwill and can increase sales in the long run.
Net income versus gross income
Gross income is the total earnings by a business or an individual in a specific time period. It is the earnings before removing any deductions or taxes. It includes all sources of income, such as salary, wages, bonuses, rental income, dividends, interest, and other earnings.
On the other hand, net income is the remaining amount when all the deductions and taxes are subtracted from the gross income. It is also called the ‘take-home pay’ for an individual or profits for a business.
Also read: What are shares
Conclusion
Understanding net income is important for an investor to analyse a company, for a business owner to assess the company's health, and for an individual to ensure a healthy financial plan. However, as it is common to get confused between gross and net income, it is important to understand the significance of net income and the distinction between gross income and net income. Now that you know what net income is, you can better manage your finances or assess a company for investment purposes.
