Your Net Income Formula to Understand the State of Your Operating Income

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Every business owner has to track the financials. You need to know how your venture is performing, and if there is enough profit to make the business worthwhile in the first place. And, what’s more important, you need income to scale and grow your company even further. Figuring out your net income is not difficult, but it is critically important.

In this post, will learn exactly how to determine your net income and how it is related to operating income. Let’s begin with some simple definitions.

What is Revenue?

Businesses generally look at what is known as “gross revenue” as they begin the process of completing a profit and loss statement over a given period of time. This is the figure of all monies that have come in from the sales of products or services. It is the starting point for ultimately figuring net income or net loss.

What is Net Income?

This is the amount of revenue that you have after all expenses of earning that income have been subtracted. Thus, if your gross revenue over a period of time, let’s say a quarter, is $10,000, and if it cost you $4,000 to generate that revenue, your net income (or net profit) is $6,000.00.

What is The Difference Between Net Income and Operating Income?

Net income and operating income are two accounting terms and figures that are directly related. However, there are some important caveats.

So what is operating income? In short, this accounting term indicates the amount of income left over after all expenses (wages, depreciation, cost of goods sold, taxes, etc.) have been subtracted. Again, this is the money you have to re-invest into your company, pay creditors, etc.

As you can see from comparing the two definitions, net income and operating income seem to be directly related, and they are. The difference is largely in how they are reported on an income statement – operating income is the net you have to use in your business, and net income is termed your “profit.” What you do with that profit, of course, is up to you. You can put it back into the business, pay off debt, invest in new products or services, take some of that profit for yourself, pay out shareholders, etc.

A Net Income Formula

Calculating the net income is critical, and not just for yourself. Creditors and investors like to see that figure, because it is an indicator of your financial health and your skills in cash flow management. Investors like to see that what they have put into your company will continue to appreciate and that there will be enough to pay dividends (is this is a factor). Creditors obviously want to know that you can meet your financial obligations to them, based on how you are operating. And you, of course, need to know that you can continue to pay yourself some salary, as well as employee wages, benefits, etc.

How to calculate net income is actually quite simple. It is total gross revenue minus the total expenses. So the formula looks like this:

Net Income = Total Revenue – Total Expenses

So that nothing is left out, it is a good idea to categorize expenses – most companies establish categories like cost of goods sold (production costs, including salaries, benefits, warehousing, shipping, etc.), interest, taxes, etc. Some even divide the cost of goods category into smaller sub-categories, so that nothing is skipped over, something that it easy to do, if you are not careful.

And this formula can also serve to calculate your operating net income as well.

One important note: Some companies substitute a “gross profit” figure for “total revenue.” Just remember, if you use this figure, it is total revenue minus the cost of goods sold, so you don’t want to subtract the cost of goods sold twice. What you will subtract are the other expenses you have not included in COGS.

Step-by-Step Net Income Calculation with Examples

Let’s look at an example of how the net income formula actually works. We have Jane and Her Boutique.

Jane owns a small boutique in a small town. She is the sole owner with no investors. She has set up a quarterly profit and loss accounting structure, using a standard accounting tool. This tool allows her to categorize all of her expenses, and these are as follows:

  • Rent and utilities (she does not own the building)
  • Insurance on the contents of the store
  • Purchased inventory (sold and unsold)
  • Wages for two part-time sales clerks
  • Equipment and/or supplies purchased or leased
  • Unpaid invoices
  • Taxes
  • Miscellaneous – advertising, etc.

At the end of a quarter, the gross revenue was $65,000. Expenses totaled $22,000.

Using the simple formula, Jane’s net income formula is this:

65,000 – 22,000 = $43,000 (net income) or (net operating income)

She may take some of that as salary and use the rest to re-invest in her business.

Note: Jane has no investors. So, even if, in another quarter of the year, she suffered a “net loss,” meaning her expenses exceeded her income, she only has herself to answer to. For larger corporations, and for those who have investors and debt, this can certainly be an issue. Investors and debtors want to see the ability to pay debt and to show appreciation in operating income, so that dividends/interest are on track.

How to Increase Your Net Income

Any business looking to scale must look first at its net income ratio. In short, this is the percentage of profit from each dollar spent. If you have a high net income ratio, you are in a better position to grow, such as launching a new product or service line, and, of course, still survive if that new launch should fail.

The other thing that your net income ratio shows is if your profits area decreasing and/or expenses increasing. These things reduce net income. Sometimes, these are the events that occur temporarily, over a one-quarter period for example, because you have re-invested income back into your business for an expansion. But, if you see net income declining and expenses increasing, then you will need to look at how you can increase that net income.

The goal will be to increase your net income ratio, and there are three ways to do this:

Reduce Expenses

This is an obvious “fix.” How can you reduce costs? Take a look at your operating expenses to see where you may be able to save:

  • Can you reduce labor costs? In Jane’s Boutique case, can she reduce the hours of her part-time clerks and assume more of those duties herself, especially during hours or days of the week when business is typically slower?
  • Can technology take over some of the operations that are currently being contracted out? Many small businesses use accountants or accounting firms, and these can possibly be replaced by some of the most recent accounting and financial software options.
  • Reducing unused services. You may have internet and phone services that are more expensive than they should be. A bit of research can reduce those costs.
  • How can marketing and advertising be optimized at lower costs? Again, technology may offer solutions that are currently being contracted out.

Increase Sales and Income

This is not as easy as it sounds, and it doesn’t happen quickly. It may involve an enhanced marketing plant, and that can involve greater initial cost. This is a long-term solution, but it can result in more sales and greater profits in the long run. It may involve additional products or services, and that will also involve a short-term investment for longer-term benefits.

In the case of Jane’s Boutique, adding product lines based upon consumer research, and then marketing those new lines, both off- and online, may be a good option. Checking out competition to see what products are gaining in popularity would provide good clues in product expansion.

Reducing Receivables Expenses

All businesses have delinquent accounts. Getting customers to pay on time and consistently is always a challenge. When they don’t pay on time, then a business has incurred an expense. Here are a few things you might try:

  • Shorten the billing cycle. You can always invoice “upon receipt” rather than use 30, 60, or 90-day payment terms. Companies that sell online usually require pre-payment prior to shipment. If you have a brick and mortar business that ships goods of any kind to customers, then invoice at the time of shipment for immediate payment. When you give customers longer time frames, they tend to become less motivated to pay. And for those customers who do not have a good track record, you can insist upon payment when placing the order.
  • You can offer customers with big bills a no-interest payment schedule over a two or three-month period. This makes the bill easier to pay, of course, and you have a better chance of ultimately getting the full payment.
  • Automate payment reminders. Rather than spend time manually tracking what has not yet been paid, set up a system of automated reminders to your debtors. These will keep your invoice in front of their eyes.
  • Offer incentives if payment it made early. Provide customers a discount if they pay up front or upon receipt of an invoice.
  • Be willing to accept newer payment methods. PayPal, e-checks, automated withdrawals and such will streamline the payment process. When customers find it easier to pay, they have a tendency to take those routes.

Conclusions

Your net income is the most important signal of the health of your business, whether that health if for you as a solopreneur, or for your creditors and investors. You need to have a clear picture of what that figure is, at least quarterly. This post provided you with a simple formula to get to this figure. That figure can tell you if you are on track or if you need to take steps that will increase it!

Photo by Iryna Tysiak

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