Understanding Net Income

Net Income is arguably the single most important measure of a company's profitability.  And in the end, generating profits is perhaps the most important responsibility that for-profit companies have to their shareholders.  In fact, it's the very reason that many companies exist.

Net Income

The best way to think about net income is in terms of profits.  It's the money left over after all the expenses of the company have been subtracted from revenues.  It's also important to understand that the calculation of net income is prescribed by a variety of accounting rules which are known as GAAP or Generally Accepted Accounting Principles.

Because companies follow the same accounting rules when reporting of net income in their financial statements, it's easier for regulating authorities - such as the Securities and Exchange Commission - as well as investors to understand the financial health of a particular company.  This standardization of reporting also allows investors to make direct comparisons between companies.

A simplified formula for calculating net income is as follows:

+ Revenues
- Expenses
= Net Income

Over the next several sections we're going to explain each of the items appearing in the income statement in more detail.  Later on, we will provide an example of an income statement so you can visualize how all these pieces fit together.

Revenue

Revenues are best defined as the price paid by customers for the goods or services sold by a company.  When a company sells these goods or services to a customer they receive money in the form of cash or an account receivable - which is money to be collected in the near future.

The revenues for any period of time are equal to the inflow of cash plus the increase in accounts receivable.  Companies recognize or "book" revenue when the goods or services are delivered to customers.  Revenues have a positive affect on net income.

Expense

Expenses are the costs that are necessary to produce and deliver the goods or services to customers.  It is the money expended by the company to obtain revenues - these are the cost of doing business.  Examples of expenses include employee salaries, advertising, raw materials, shipping, warehousing, income taxes as well as the decrease in the value of certain assets via depreciation.

Expenses have a negative affect on net income.  The expenses reported for any period of time should be those incurred to produce the revenues associated with that same period of time.  This approach of aligning revenues and expenses is referred to as the matching principle.

Matching of Revenues and Expenses

The matching principle refers to the matching of revenues and expenses.  By aligning the expenses needed to generate revenues in a given period of time the income statement more accurately reflects the appropriate level of net income associated with that same period of time.

For example the reporting of annual net income should match the revenues for the year with the expenses associated with generating those revenues.  This is why it's so important to recognize revenues when they're earned and expenses when they're incurred.  When these two components of the income statement are matching, then net income for the period will be reported correctly.

Income Statements

Net income is usually reported as the final line item on a company's income statement.  We're going to talk in more depth about building an income statement later on.  But for now it's important to understand that net income really provides us with an indication of the financial health of a company.

Operating Section

The operating section of the income statement is used to report the revenues and expenses associated with the company's primary business operations.  The revenues and expenses appearing in this section provide the investor with an indication of how well the operations of the company performed.

Net Sales or Revenues

Revenues or sales are the first items normally reported in the income statement.  Revenues are all of the cash and credit sales; and companies usually recognize revenues at the point their goods or services are delivered to the customer.  If the company is reporting net sales, then they are simply taking the total revenues received in a time period and subtracting from it any sales discounts, allowances, or returns.

Cost of Goods Sold

The cost of goods sold is the cost of the materials that were used to produce the sales. The cost of goods sold can include raw materials or merchandise removed from inventory.  If the items are typically shipped to the company's warehouses, then we'd also include freight charges or transportation-in costs.

Operating Expenses

Operating expenses are all of the costs associated with operating the company.  Typically, operating expenses include costs directly related to selling the goods or services, administrative, and general expenses - sometimes referred to as SG&A.

Selling Expenses

These are the expenses that are linked to the selling of the company's produce or service.  Typical selling expenses include sales salaries and commissions, travel and entertainment, freight or transportation-out, postage, advertising and all other costs that the sales arm of the company might incur such as depreciation of sales equipment.

Administrative and General Expense

These expenses appearing in the income statement are the costs associated with the administration of the company's operation.  Typical A&G costs include the salaries of the company's officers, office worker salaries, legal services, insurance, utilities, depreciation expense on office equipment and buildings, stationary, and other office supplies.

Income from Operations

When all of the operating expenses mentioned above are subtracted from the net sales revenues then the resulting value is considered the income derived from operations.  This is a very important item appearing on the income statement because it's a good indicator of how profitably a company is with respect to their principal business operations.

Non-Operating Section

Companies can also realize revenues, gains, expenses and losses that are not directly related to their principal business.  So these items are reported on the income statement outside of the operating section.  These are either unusual items or they occur infrequently - not both as discussed below in extraordinary items.  The non-operating section is usually broken down into two subsections - other revenues / gains and other expenses / losses.

Other Revenues and Gains

This category includes revenues and / or gains and these items are generally reported net of any related expenses.  Once again, these are non-operating transactions such as dividend revenues or rental income.

Other Expenses and Losses

Just like the other revenues and gains, the other expenses and losses are reported net of any associated income and are non-operating transactions.  The most common item appearing in this section would be interest expense on the company's bonds or notes.

Income Before Income Taxes

Income before income taxes, or IBIT, provides the investor with a good feel for the income generated by operations with consideration for some non-operating gains and losses.  Some of the adjustments to income later on will address things that happen very infrequently and are also unusual - such as extraordinary items and discontinued operations.

Income Taxes

Income taxes on the income statement include both federal and state level income taxes.

Other Adjustments to Net Income

Sometimes companies need to report very unusual items.  These are changes that don't happen very frequently and are often "discounted" by market analysts because they are so unusual that they wouldn't normally be considered when looking at a company's longer-term outlook.  Adjustments falling into this category include:

• Discontinued Operations - Gains or losses on the sale of a portion of the business's operations.
• Extraordinary Items - These are items that are both infrequent in nature and unusual.
• Changes in Accounting Principle - Any time a company changes their accounting approach - such as inventory pricing or depreciation rates - that company needs to explain, or disclose, the cumulative effect of that change on their income statement.

Simple Income Statement Example

If you were to model all of the above mentioned items then the result would be an income statement for the company you're evaluating.  To demonstrate what a simple income statement might look like we've put together the following example:

Comparative Income Statement

In our next article in this series we're going to provide some guidance on the interpretation of the income statement and net income - including its link to earnings per share.  Then we'll finish up with a more detailed explanation of how to put together an income statement including some additional examples as well as worksheets you can download.

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