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Learn moreNet Income: Definition, Interpretation, and Sample Calculations
Net Income is the “bottom line” on a company’s Income Statement and represents its net sales minus all expenses in the period – Cost of Goods Sold, Operating Expenses, Interest, Depreciation/Amortization, and Taxes; it does NOT represent cash flows during the period but rather the “accounting profits.”
Net Income: Definition, Interpretation, and Sample Calculations
Net Income Definition: Net Income is the “bottom line” on a company’s Income Statement and represents its net sales minus all expenses in the period – Cost of Goods Sold, Operating Expenses, Interest, Depreciation/Amortization, and Taxes; it does NOT represent cash flows during the period but rather the “accounting profits.”
At a basic level, you can think of Net Income as “Revenue – Expenses – Taxes.”
It’s sort of like what you as an individual might save up each year after working, paying for your living expenses, and paying taxes to the government.
However, there is some subtlety to this definition.
First, Net Income deducts “non-cash expenses” and includes “non-cash revenue.”
For example, if a company sells a product to a customer and delivers this product, but the customer has not yet paid in cash, the company still records this as Revenue on the Income Statement, and it still affects the company’s Taxes and Net Income.
Also, Net Income deducts many non-cash expenses such as Depreciation, as they represent a company’s spending on long-term assets (factories, equipment, etc.) from previous periods “spread out” over many years.
Second, Net Income does NOT reflect all cash inflows and outflows!
For example, if a company issues $200 of Debt and then buys a factory for $100, neither one directly affects Net Income.
Why?
Because they both correspond to long-term items that will last for many years.
The accrual principle of accounting is critical here: To appear on the Income Statement and affect Net Income, the line item must correspond to something in the current period.
Even if this line item does not represent a cash inflow or outflow, it still affects Net Income because it matches the time period.
Files & Resources:
How to Calculate Net Income
All companies list Net Income directly on their Income Statements, but if not, you can calculate it with:
Net Income = Revenue – Cost of Goods Sold (COGS) – Operating Expenses – Net Interest Expense +/- Other Non-Core Items – Taxes
Here’s an example for Steel Dynamics:
Net Income = $22,260,774 in Net Sales – $16,142,943 in COGS – $545,621 in SG&A – $452,551 in Profit Sharing – $27,837 in Amortization – $91,538 in Interest Expense – ($20,785) in Other Income – $1,141,577 in Income Taxes = $3,879,492 in Net Income.
This calculation is pointless here because the company lists this same Net Income figure at the bottom of its Income Statement.
Variations of Net Income: Net Income Attributable to Parent and Net Income to Common
Some companies may own stakes in other companies, which complicates their accounting and financial statements.
These topics are complex and not appropriate for this article, but please see our tutorial on the equity method of accounting to learn more about minority stakes in other companies and the one on consolidation accounting to learn about majority stakes.
The short version is that these partial ownership stakes create “additional” Net Income lines, such as Net Income from Equity Investments and Net Income Attributable to Noncontrolling Interests.
Below these lines will be something like “Net Income Attributable to [Company Name],” which is the one you should use for analytical and valuation purposes.
You should use this “very bottom” Net Income because you want it to reflect the company’s partial ownership in other companies.
Here’s an example for Steel Dynamics:
Some companies may also have Preferred Stock, a Debt-like form of financing that is more expensive than Debt because it has higher “coupon rates” (i.e., interest rates), and this interest, called “Preferred Dividends,” is not tax-deductible.
When this happens, there will be a deduction for Preferred Dividends toward the bottom of the Income Statement, with a line like “Net Income to Common” right below it.
Again, you should always use this “very bottom” Net Income in financial models and valuations.
Here’s an example for Bank of America:
Net Income in Financial Models and 3-Statement Projections
In most cases, Net Income is not a driver in models.
Instead, it’s an intermediate number or output when you project the three financial statements or set up a cash-flow model for a company.
In a 3-statement model, Net Income from the Income Statement flows into the Cash Flow Statement as the first line there.
Everything else below it on the Cash Flow Statement represents an “adjustment” to this Net Income number, which produces the “Net Change in Cash” at the very bottom of the CFS.
For example, companies often add back non-cash expenses, such as Depreciation and Amortization, and they also deduct cash outflows that did not appear on the Income Statement, such as for Capital Expenditures (the factory purchase example above).
Here’s an example from Steel Dynamics:
Net Income is a critical step when estimating the company’s cash flow because it’s usually the starting point.
You make many adjustments from here, but you need to understand the company’s after-tax profits before doing anything else.
On the Balance Sheet, Net Income flows into the Retained Earnings line within Common Shareholders’ Equity (or the Statement of Owners’ Equity).
The Balance Sheet stays balanced because Net Income affects Equity on the Liabilities & Equity side, and the Net Change in Cash affects Cash on the Assets side.
Meanwhile, everything in between these top and bottom lines on the Cash Flow Statement affects their corresponding line items on the Balance Sheet.
Net Income in Valuations
When valuing companies, you can take a company’s Equity Value (Market Cap) and divide it by its Net Income to get the Price-to-Earnings multiple, also known as the P / E multiple.
For example, if a company’s Equity Value is $1,000, and its Net Income is $100, its P / E multiple is $1,000 / $100 = 10x.
By itself, this number doesn’t “mean” anything.
It’s like visiting a house you’re considering purchasing and finding that it costs $500 per square foot.
By itself, $500 per square foot is meaningless – it means something only when you compare it to other, similar properties in the area.
If everything else costs $800 per square foot, perhaps you’ve found a great deal!
Or maybe you find that this “cheap house” contains corpses in the basement, so it’s not such a great deal after all.
It’s the same with P / E: You must compare your company to other, similar companies with similar financial profiles (“comparable companies”) to say anything meaningful.
Higher P / E multiples mean a company is more expensive, but that needs to be taken in context.
If the company is growing more quickly than its comparable companies, perhaps its higher P / E multiple is justified.
Besides its use in the P / E multiple, Net Income is a component of the Return on Equity (ROE) and Return on Assets (ROA) metrics, which are widely used in financial statement analysis.
These metrics evaluate a company’s “efficiency” in using its Total Assets or Equity to generate after-tax profits.
If a company has higher ROA and ROE figures than other, similar companies, but it is trading at similar P / E multiples it could be a sign that it is undervalued.
All these metrics – ROA, ROE, Net Income, and P / E – are particularly important in the financial institutions (FIG) sector because banks and insurance firms are valued based on them.
Since these firms earn profits in direct proportion to their Total Assets and Equity, you can evaluate their market value in relation to these metrics.
Net Income vs. NOPAT vs. Operating Income (EBIT) vs. EBITDA
Net Income is closely related to many other metrics used in financial statement analysis and valuation, such as Net Operating Profit After Taxes (NOPAT), Operating Income (EBIT), and Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA).
To understand the differences, please see our comparison table and full tutorial on Net Income vs. EBIT vs. EBITDA.
The short version is that EBIT and EBITDA are both pre-tax and pre-interest metrics, and EBITDA also excludes or “adds back” significant non-cash expenses, such as depreciation and amortization.
By contrast, Net Income deducts taxes, interest, and these major non-cash expenses.
Therefore, EBIT and EBITDA are often closer to a company’s cash flow than Net Income… but not entirely since they exclude taxes and the interest expense.
For more, please see the comparison article and table there, as the differences are nuanced.
About Brian DeChesare
Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.
