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Net Income

NI flows through the balanced sheet through retained earnings, and through the cash flow in the indirect method.

What is Net Income?

Net income is the amount of accounting profit a company has left over after paying off all its expenses. Net income is found by taking sales revenue and subtracting COGS, SG&A, depreciation, and amortization, interest expense, taxes and any other expenses.

Net income is the last line item on the income statement proper. Some income statements, however, will have a separate section at the bottom reconciling beginning retained earnings with ending retained earnings through net income and dividends.

net income
Source: Amazon SEC filing

 

Other names for Net Income

The bottom line of a company’s income statement has three names, which include:

  • Net Income
  • Net Profit
  • Net Earnings

All three of these terms mean the same thing, which can sometimes be confusing for people who are new to finance and accounting.

In this article, we will use all three terms interchangeably.

 

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Ties to other financial statements

The net income is very important in that it is a central line item to all three financial statements. While it is arrived at through the income statement, the net profit is also used in both the balance sheet and the cash flow statement.

Net income flows into the balance sheet through retained earnings, an equity account. This is the formula for finding ending retained earnings:

Ending RE = Beginning RE + Net Income – Dividends

Assuming there are no dividends, the change in retained earnings between periods should equal the net earnings in those periods. If there is no mention of dividends in the financial statements, but the change in retained earnings does not equal net profit, then it’s safe to assume that the difference was paid out in dividends.

In the cash flow statement, net earnings are used to calculate operating cash flows in the indirect method. Here, the cash flow statement starts with net earnings and adds back any non-cash expenses that were deducted in the income statement. From there, the change in net working capital is added to find cash flow from operations.

 

 

Profitability and Return on Equity

Net earnings are also used to determine the net profit margin. This is a handy measure of how profitable the company is, when compared to its past self or other companies.

Net profit margin is also used in the DuPont method for decomposing ROE. The basic DuPont formula splits ROE out into three components:

ROE = Net Profit Margin x Total Asset Turnover x Financial Leverage

Analyzing a company’s ROE through this method allows the analyst to determine the company’s operational strategy. A company with high ROE due to high net profit margins, for example, can be said to operate a product differentiation strategy.

 

Difference between net income and cash flow

Net income is an accounting metric and does not represent the economic profit or cash flow of a business.

Since net profit includes a variety of non-cash expenses such as depreciation, amortization, stock-based compensation, etc., it is not equal to the amount of cash flow a company produced during the period.

For this reason, financial analysts go to great lengths to undo all of the accounting principles and arrive at cash flow for valuing a company.

To learn more, explore CFI’s financial modeling courses.

 

 

Additional resources

CFI’s mission is to help anyone become a world-class financial analyst.  The resources below are designed to give you the tools and training you need to become a great financial analyst:

  • How the 3 statements are linked (free webinar)
  • Depreciation expense
  • Valuation methods
  • Financial modeling guide

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