# Net Income

Understand the Definition and Formula of Net Income

• What is net income?
• What is the formula for calculating net income?
• Which expenses are subtracted to calculate net income?
• What are the shortcomings of the net income metric?

## How to Calculate Net Income

Often referred to as the “bottom line” on the income statement, net income represents a company’s residual profitability, inclusive of all expenses incurred.

Net income is the amount of revenue left over once all expenses have been accounted for, such as:

• Cost of Goods Sold (COGS) – The direct costs related to the company’s core operations generating revenue.
• Operating Expenses (OpEx) – The indirect costs related to company operations (e.g. selling, general & administrative)
• Non-Operating Costs, net – The expenses unrelated to the company’s core operations – net of any non-operating income (e.g. marketable securities, short-term investments).
• Taxes – The local, state, and federal taxes paid to the government.

Since each line item above net income such as revenue and expenses is recorded under accrual accounting standards, net income is also considered a measure of the “accounting profits” of a company.

## Net Income Formula

The calculation of net income is equal to the pre-tax income of a company – i.e. earnings before taxes (EBT) – minus tax expenses.

###### Net Income Calculation

The step-by-step process of calculating net income is as follows:

1. Revenue – Cost of Goods Sold (COGS) = Gross Profit
2. Gross Profit – Operating Expenses (OpEx) = Operating Income (EBIT)
3. Operating Income (EBIT) – Interest = Pre-Tax Income (EBT)
4. Pre-Tax Income (EBT) – Tax Expense = Net Income

In financial models, net income is never explicitly projected, but rather, the line item is a function of other operating assumptions, most notably:

Net income can be divided by revenue to calculate the net profit margin, another frequently-used profitability metric.

###### Net Profit Margin Formula

Net Profit Margin = Net Income / Revenue

## Apple Net Income Example

As we can see from the screenshot of Apple’s 2021 income statement, the beginning line item is revenue, and after deducting all operating and non-operating expenses, the ending line item is net income.

Below net income, we can also see a separate section where the earnings per share (EPS) are calculated on a basic and diluted basis.

Apple Income Statement (Source: Apple 2021 10-K)

## Shortcomings of Net Income

As a measure of profitability, net income can misleadingly portray a company’s financial well-being from a liquidity and solvency standpoint.

For instance, a company could consistently produce positive net income yet struggle to collect cash payments for sales made on credit – i.e. accounts receivable (A/R).

Despite not actually having retrieved the payment from customers, the sale is recognized as revenue under accrual accounting.

Another issue is that discretionary corporate decisions can greatly affect a company’s net income.

###### Discretionary Decisions Examples

Some of the more impactful discretionary management decisions are as follows:

• Useful Life Assumptions for PP&E (Depreciation Expense)
• Inventory Recognition Policies (LIFO vs FIFO)
• EPS Increase from Share Repurchases (Treasury Stock)
• Debt % in Capital Structure (Leverage Ratio)

The fact that debt is factored into net income through interest expense causes net income to be less practical for peer comparisons.

Compared to other non-levered metrics like operating income (EBIT) and EBITDA, net income is used far less often in relative valuation.

Long story short, most of the limitations to net income stem from the imperfections of accrual accounting that make net income prone to the risk of earnings management (i.e. manipulation of numbers) and a potentially misleading depiction of a company’s operations.

For that reason, the cash flow statement reconciles net income, the starting line item, adjusting for the actual cash inflows/(outflows) to assess the true cash impact from operations, investing, and financing activities.

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