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Net income:

Net income is the amount left with the company after subtracting all the expenses, including taxes from the total revenue.

Suppose that Company A is in the business of manufacturing tennis racquets. It has several buildings in its possession. Company generates its main revenue from sales of racquets. Let us assume that the sale of racquets for the financial year under consideration is United States Dollar (USD) 50 million. It also takes rent from some parts of its buildings from its tenants. Assuming the rent is USD 5 million, the total revenue of Company A becomes USD 50 million + USD 5 million = USD 55 million.

The expenses of the company come from cost of goods sold (COGS), operating expenses, depreciation & amortization and tax. Suppose that the company has cost of goods sold equal to USD 10 million, operating expenses equal to USD 5 million and depreciation & amortization of USD 2 million. Thus, total expenses before tax becomes USD (10+5+2) million= USD 17 million.

To calculate net income, firstly subtract expenses from total revenue, i.e. USD 55 million- USD 17 million= USD 38 million. Assuming corporate tax rate to be 40%, the net income becomes USD (38 million*(1-40%))= USD 22.8 million.

Net profit (NP) ratio:

It is a measure of profitability. It is one the profitability ratios that financial analysts use to determine how a company is faring in terms of profits generated.It is the ratio of net profit to net sales and then multiplying the result by 100. From the example given above, net income is USD 22.8 million. Net sales are the total sales done by the company after considering returns, allowances and discounts. For simplicity, let's assume that the net sales are equal to sales as given in the example above, i.e. USD 50 million. 

Hence, net profit ratio = (Net income/net sales)*100 = (22.8/50)*100 = 45.6%.

Interpretation: Generally a high NP ratio signifies efficient management of business. But the NP ratio of a company in a financial year should be compared with the ratios of previous years and competitors. A company can keep its NP ratio low by keeping low margins in order to gain market share while it can keep its NP high ratio by charging higher margins.

How to Calculate Net Income with Ending Inventory?

Ending inventory is used to calculate cost of goods sold (COGS) which is a part of expenses. Suppose that a company has inventory at the beginning of the year equal to USD 12 million and then purchased inventory of amount USD 5 million, then total inventory available becomes USD 17 million. Assuming that the company has ending inventory of USD 10 million then cost of goods sold is calculated by subtracting ending inventory from total inventory available, i.e. USD (17 - 10 ) million = USD 10 million. The COGS obtained in this way is added to operating costs to find out total expenses. The rest of the method to calculate net income is the same, i.e. subtracting total expenses from total revenue and taking care of taxes.

How to Calculate Net Income from Retained Earnings?

Net income is connected to retained earnings through balance sheet statement. To calculate net income from retained earnings, the difference between retained earnings of current year and previous year is found out and adjustments are done to include the effect of dividends distributed to shareholders.

Suppose that retained earnings at the end of the previous year is USD 10 million and retained earnings at the end of the current year is USD 20 million. Dividend distributed to shareholders in the current year is USD 2 million. The difference between retained earnings of the current year and the previous year is USD (20-10) million, i.e. USD 10 million. Then, dividend is added to the difference obtained in the previous step. Thus, net income becomes USD (2+10) million, i.e. USD 12 million. If the net income is positive, like in this case, the company is in profit in the current year while if it negative, the company is in loss in the current year.

Net income vs net profit

Net income is calculated in two ways: net income before tax and net income after tax.

Net income before tax: It is calculated by subtracting total expenses incurred by the company from its total revenue without considering taxes.

Net income after tax: It is calculated by subtracting total expenses incurred by the company from its total revenue and then subtracting the total amount of tax. It is the same as net profit.

Revenue - Cost of goods sold (COGS) gives gross profit.

Earnings before interest, tax, depreciation & amortization (EBITDA) is called cash operating profit.

When depreciation & amortization are subtracted from the above, operating profit (EBIT) is obtained.

When interest is subtracted from the above, profit before tax (PBT) is obtained. It is also called net income before tax.

When taxes are deducted from the above, we obtain profit after tax (PAT). It is also called net profit and net income after tax.

 Guide for students who are not familiar with net income problems before?

  • Go through basics of accounting from good books and reliable internet sources.
  • Go through the basics of all the types of financial statements.
  • Download annual report of a company and study it completely. Don't go for banks initially since their financial statements are more complex.
  • Download financial statements of the company you are studying over the past 10 years. Make an excel sheet and try to recreate the formulae. For examples, try to calculate total income by adding up all the sources of income of the company, and then repeat the exercise for other components of financial statements. You can take the help of websites like yahoo finance and money control for downloading the financial statements directly in MSExcel.
  • Link the excel sheets of financial statements, i.e. balance sheet statement, profit and loss statement, cash flow statement and retained earnings statement with each other.
  • Try to calculate net income using balance sheet and profit and loss statements and compare the numbers.

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