In the most basic sense, net income is your company’s profit after expenses as shown on the bottom line of your profit and loss statement. The basic formula for net income is revenue (aka gross income) minus cost of goods sold, expenses, taxes and interest. Similarly, think of this as the net income line on your pay stub – your gross earnings less deductions, or your “take home pay”.
Net income can be the most important number on your P&L, (and first number many refer to) but there is a process to getting there, and understanding that process can be more important than the numbers on the report itself. First, you want to review your income – this is a good barometer of what your business is doing in the marketplace. By comparing this number to prior periods and/or an established budget or forecast, the variances can be a key indicator of what is working and what is not so you know what levers to pull to achieve your goals. It is also important to know that your revenue can cover expenses incurred by your business.
The next section is “Cost of Goods Sold”. “COGS” as it is also called, are expenses directly incurred in the production of the service or product your company sells. This includes labor, materials, subcontractors, etc. Directly below COGS you will find “Gross Profit” this is your next key number of revenue minus COGS. Gross profit is your initial profit after subtracting the costs to produce your service or product. Also referred to as “Gross Margin”, this is a key financial metric used in determining profitability. If you divide COGS by revenue, shows profit as a percentage of sales – it represents the portion of each dollar of revenue you retain after COGS.
Next are expenses – these are all the other costs related to operating your business. This is labor, rent, marketing, etc. Some will be fixed such as rent, and the rest variable due to seasonality, timing, or market conditions. After expenses are factored in, you will see “Net Operating Income”, simply gross profit less expenses.
The next sections are specific for interest, taxes, depreciation and amortization incurred in the period and may or may not be on the P&L depending on your business.
Now we arrive at the proverbial “bottom line” of your business, net income. Just like your net earnings on your pay stub, this is what remains after income less COGS, expenses and other items.
Net income is one of the most important numbers on the P&L, and links to both the balance sheet and cash flow statement. Positive net income will increase the owner’s capital account, or owners equity, and unfavorable net income will decrease the same accounts and can be found on the balance sheet.
For each of the key areas highlighted above, it is important to see what is driving variances when comparing to prior periods, budget or forecast. Looking at trends over time may show surprising results, or help solidify action needed to achieve goals – whether it is cost cutting, realizing an increased cost of fuel is impacting your margin, or needing to hire additional staff if subcontracting is high.
Reviewing your P&L on a monthly basis is invaluable and does not take a lot of time, and is proven to help build a healthier business by knowing which levers to adjust and what factors are driving success – or not.
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