Net income is sometimes called Net Profit, Bottom Line, or Net Earning. It is the net earnings from the operating activities and other income for a specific period of time.
Net Income results from gross profits for the specific period less than their corresponding expenses of the same period. Those expenses are Cost of Goods Sold, Operating Expenses, Interest Expenses, and Taxes.
The net income is significantly affected by accounting policies, frameworks, and accounting principles used to prepare its financial statements. For example, Incomes recognized that using a cash basis is different from incomes using an accrual basis. Different accounting policies or estimates could produce different results. For example, differentiation of depreciation rate could result in different bottom lines.
This is the reason why people say Net Income is the accounting figure which could significantly affect by accounting policies, and judgement as the result of management bias.
Net Income Formula:
The following is the Formula of Net Income:
Less Cost of Goods Sold $ (XXX)
Equal Gross Profit $XXX
Less Operating Expense ($XXX)
Equal Profit before interest and tax $XXX
Less Interest Expenses ($XXX)
Equal Profit Before Tax $XXX
Less Tax Expenses ($XXX)
Net Income $XXX
Another Net Income Formula:
Net Income = Total Profit – Total Expenses
In this Net Income Formula, all expenses and incomes recorded here must have occurred or cut-off for the same period. As you could see here from top to bottom before coming to Net Income, we got five important items:
- Revenue or sometimes called Sales Revenue
- Cost of Goods Sold,
- Operating Expenses,
- Interest Expenses ( only if the company have debt or similar), and
- Tax Expenses.
Net Income is significant for the company as it tells the shareholders, investors, management, employees, banks, investors, creditors, customers, and suppliers about its performance.
These stakeholders will use the Net Profit to make analyses based on their own purpose. For example, shareholders and investors will use the bottom line to compare or benchmark with competitors as well as others’ investment portfolios so that they could assess if the current company could generate the return as their requirement or not.
Employees might use the bottom line to check if the company could have enough Net Income to continue its operation to secure their job.
The disadvantage of net income is that it shows only the company’s short-term performance. If this figure is a factor that uses by Board as the performance measurement for the management team or company, it is a big risk to the company. The reason is accounting policies and judgment could manipulate this figure.
It also motivates management to focus on the short-term by discouraging investment in new assets. It also encourages management to reduce training expenses, research, and development.
ABC is the company operating in the manufacturing industry, and it has the following transactions for the period of 31 December 2016. Assume that all figures are correct and correctly cut-off.
|Cost of Goods Sold||(500,000)|
What is the Net Profit of ABC for the period of 31 December 2016?
Well, here is the answer. Let pick up the figure provide into the framework provided above, and here is what we have:
Based on the Net Income Formula above,
|Cost of Goods Sold||($500,000)|
|Equal Gross Profit||$500,000|
|Profit before interest and tax||$480,000|
|Profit Before Tax||$475,000|
The Bottom Line of ABC for the period of 31 December 2016 is $465,000.
As discussed above, the bottom line is that accounting profit could be manipulated and affected by accounting policies and management bias.
Therefore, for better analysis, we do need detailed information, not just only financial data, but also financial information like management integrity, nature of each item in the income statements, and reasons for going up and down for a specific period of time.
These are all the main factors that we need to know and express in our analytic report on the Net Income section. For example, as we can see in the example above, the Cost of Goods Sold is 50% of Revenues or 100% of Gross Profit.
The cost of Goods Sold here is significantly affected by the ending balance of inventories at the end of the period. The ending balance of the inventories is also significantly affected by the methods of how they are valued and measured.
Another thing that we need to consider, and probably the most important, is depreciation policies. Most fixed assets are new for the new operating company; therefore, the depreciation would be large in the first years in general.
Yet, this difference also depends on the policies the company is using. For example, suppose the company uses the straight-line depreciation method. In that case, the depreciation expenses are high, while the machine might not be used at its best optimal in the first years.
Interest expenses are also high compared to Net Income, and it’s not because of operating loss. The interest expenses might be because of the debt or financial lease that the company invests in for its assets.