Businesses are set up to make money for their owners. The business must continue to make money to stay in business. This "money" that the business makes is determined by how much money the business takes in, minus how much the business spends to make this money.
There are three terms that describe this process of "making money." They are:
- Net Income
Net income is the same as the "profit" of a business, or its "earnings." For all of these terms - profit, net income, or earnings - we are talking about a net amount, including both the income (revenue) of the business and deductions to that income.
Gross Income vs. Net Income
"Gross" in accounting is a general term meaning an amount from all sources before anything is taken away. The term "net" means that some amount is taken away.
The typical calculation is:
Minus withholding, deductions, expenses
Equals Net income
A person's gross pay is the amount of their paycheck before withholding for federal income tax, FICA tax (for Social Security/Medicare), and any deductions.
A business gross income (also called gross receipts) is all the income the business received from all sources before subtracting costs or expenses.
Net Income for Individuals
Net income is a useful financial management term for an individual or a family. A personal net income calculation begins with the money coming in for you and your spouse from all the various sources:
- Income from employment
- Income from a business
- Income from Social Security or other benefits
- income from investments
Then, to get net income, you must deduct withholding of income taxes, deductions for Social Security and Medicare taxes, and other pre-tax benefits like health insurance premiums and tax credits.
Earnings for Individuals, Investors, or Businesses
The term "earnings" is a special case because it can be used for both businesses and individuals. An individual can have earnings from wages or salary or from other payments. For example, you can have Social Security earnings, which are credited to you toward your Social Security benefit.
For an investor, earnings can be compared to the price of a stock in a price to earnings ratio to get the relative value of a stock.
For a business, the term "earnings per share" is a way to measure the health and profitability of the company. Earnings are shown for individual shareholders and for the corporation as a whole. The term "earnings per share" relates to how the earnings of a corporation are divided among the individual shareholders.
How Net Income Works for Businesses
A business shows the calculation of net income on a financial report titled a "Net Income" or Profit and Loss financial report. Again, since the terms mean the same thing, either title can be used.
The Net Income statement has a specific form:
- The title shows the name of the company, the name of the report (Net Income or P&L), and the date of the report (For example: "As of December 31, 2018")
- The gross income of the business, less any returns or adjustments to gross income
- The expenses of the business are shown, in alphabetical order. These are all legitimate business expenses.
- Any depreciation expenses and taxes are shown as separate deductions.
After all the calculations, the resulting figure is the net income or profit or earnings of the business.
If the Business Has a Loss
Of course, a business may not bring in enough income to cover its expenses. In that case, the business has:
- Negative earnings
- A loss (as opposed to a profit)
- Net Loss, as opposed to net income
The opposite of net income is a net loss. In this case, the expenses and other reductions are greater than the income of the business.
A special kind of tax loss, called a net operating loss, separates a loss from normal operations of the business from investment losses (capital losses), nonbusiness deductions, and other non-operating losses.
In some cases, you can't take business losses, called excess losses, that are more than business income for the year. The amount of an excess loss can be carried over to a future tax year.
How Net Income is Used in a Business
The net income of a business is used as a way for the business owner to measure success, but also as a way to determine the tax for the business. Net income is used:
- To determine the tax paid by a sole proprietor business filing business taxes on Schedule C (as part of the owner's Form 1040/1040SR)
- To determine self-employment tax (Social Security and Medicare tax) for self-employed business owners
- To determine tax for individual partners and LLC members and for S corporation owners who report their share of the income from the business on Schedule K-1 on their personal tax returns
- To determine tax for corporations (called "Taxable Income")