If you’ve ever wondered where the term “bottom line” comes from, just know it’s referring to a company’s net income.
Why is this?
Simply put, a company’s net income appears near the bottom of its income statement and is determined after all expenses are weighted against total revenue.
Net income, sometimes referred to as net profit, isn’t just important for the company itself, but for anyone who has financial ties to the company.
But before we dive more into net income’s importance, let’s determine how to calculate it first.
A variety of expenses are required for a company to operate. As the saying goes, “you have to spend money to make money.”
After all of the “spending” is over, it’s time to calculate what has been made.
Gross profit - Total expenses = Net income
Here’s an example to further explain the above formula:
$1.4 million - $800,000 = $600,000 net income
Obviously, there’s a lot to decompose before arriving at your net income. I’m going to break down each structure of the formula, starting with gross profit.
Gross profit is essentially all of a company’s sales throughout a period, minus the Cost of Goods Sold, or COGS.
Why is COGS part of a company’s total revenue? Well, COGS is actually recorded as a business expense on income statements.
For a company to sell something, they first need to produce it. The costs associated with developing a product is factored into COGS. This includes raw materials, direct labor, production equipment, and more.
In other words, COGS is the cost of doing business. Now, onto total expenses.
If gross profit consists of all sales and production costs, total expenses are everything else.
Perhaps the largest of these expenses are operating expenses, sometimes referred to as fixed costs.
Operating expenses include payroll, employee benefits, marketing, advertising, third-party consulting, insurance fees, and even depreciation of equipment.
| Think about this way: If COGS is the cost of doing business, operating expenses are the costs of staying in business. |
Below operating expenses are interest expenses. This basically includes the accrued interest on any payable loans, bonds, debt, lines of credit, and any other borrowings.
Then there are taxes, which can greatly differ depending on the size of the company, its filing status, eligible deductions, and more.
On a hypothetical income statement, a company will record its gross profit near the top and its total expenses right below. The figures will then be subtracted to find the net income – the bottom line.
| Company A Income Statement (2017) | |
| Total sales (revenue) | $5,600,000 |
| Cost of Goods Sold | $4,200,000 |
| Gross profit | $1,400,000 |
| Operating expenses | $480,000 |
| Interest expenses | $200,000 |
| Taxes | $120,000 |
| Total expenses | $800,000 |
| Net income (bottom line) | $600,000 |
Now that you know what goes into net income, let’s discover why it’s important.
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Net income isn’t just a company’s bottom line, but an indicator of its short and long-term health. This is important for those with financial ties to a company, but also those looking to invest.
Shareholders closely monitor a company’s net income to ensure the value of their shares is being upheld. A healthy net income means higher stock prices, which makes for happy shareholders.
On the other end, a falling net income can hint to shareholders that the company is not capable of compensating them. This can negatively affect the value of stocks.
Investors are always looking for the “next best thing,” but before taking up much of an interest, they will monitor financial risk analyses on your company first.
A falling net income shows investors that the company is high risk. A rising net income and happy shareholders are much less risky and much more attractive to investors.
Most importantly, investors need to know how long it’ll take for them to recover an investment in a company. Net income helps them determine this.
To obtain a business loan of any sort, creditors place great importance on a company’s net income. This shows the creditor a company’s ability to pay back a loan. Net income can also be used to determine a business loan’s interest rate.
For a company to be profitable, it needs to have lasting power. A rising net income allows a company to stay in business for longer, keeps shareholders happy, attracts new investors, and keeps competitors on their toes.
In addition to net income, some companies determine its health through gross margin. This is done by dividing sales from gross profit and obtaining a percentage. This percentage can then be used to evaluate how a company stacks up against its competitors.
However you determine the health of your company, be sure to utilize the right accounting software in your tech stack.
This software automates lengthy accounting processes, integrates with other tools, and is tailored for businesses of all sizes and industries.
We get it. Accounting software comes at a price. That’s why we compiled the top 11 free accounting software tools to expect in 2019.
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