What is Net Loss?
Net loss is an accounting term, and it refers to a negative value for income. In other words, a company incurs a net loss when the expenses for a specific period are higher than the revenues for the same period. The principle for which expenses and revenues must refer to the same period is called the matching principle. The period considered is typically a fiscal year.
Revenues and expenses are part of the income statement, and at the bottom line, you can read the net income or net loss. When you subtract the expenses and costs from revenue, the result will be either positive or negative. A positive result is called net income, and a negative result is a net loss.
Key Components of Net Loss
To better understand what a net loss is and how to calculate it, let’s break down the key components from the definition we saw above.
The term revenue refers to all the goods or services that a company sells to the public. In the income statement, the revenues are positive items.
Looking at the revenues, an increase is a signal that the company is growing, selling more assets, and raising more money. In this case, the company can increase its investments or expenses. If the revenues are decreasing, it means that the company is shrinking. If it wants to remain profitable, it needs to reduce the expenses as well.
The expenses in the income statement are all the items with a negative sign. They are all the costs the company incurred to provide the services or to produce the goods it is going to sell.
Usually, there are three macro-categories of expenses:
- The cost of goods itself (e.g., the cost of the raw materials used for the production)
- The operating expenses (e.g., salaries, rent, utilities, amortizations, etc.)
- The interest expenses (interests due to the shareholders)
For a company to be profitable, all its expenses must be lower than its revenues. In other words, the revenues must be substantial enough to settle all the expenses and compensate the owners. When it does not happen and the expenses exceed the revenues, the company incurs a net loss.
The income statement is a document each company needs to provide by law. It is a financial statement referred to a specific period, and it reports all revenues and all expenses of the company. The structure of an income statement is similar for all types of companies, even if some specific industries can include some specific items. Below an example of a simple income statement for Company XYZ.
Importance of Net Income/Net Loss
Net loss or net income is a key indicator used to evaluate the position of a company in a specific period. However, a net loss can occur in one year if net consistent losses remain even in the following years.
Matching Principle and Accrual Accounting
The matching principle states that to calculate the net income/loss, all the expenses and revenues must refer to the same period.
The matching principle is a key factor in the calculation of net income/loss. All the expenses related to a specific earned income must be considered in the calculation regardless of when they will be actually paid.
A good example is payroll wages. An employee who worked in December 2019 will not be paid until January 2020. However, the company, in the calculation of the net income or net loss for 2019, will record the payroll expense in December 2019, even if it will be paid in January 2020. The process is known as accrual accounting.
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