NET INCOME FORMULA
Savira Auliyah
Business activity can be considered as a dynamic system that invariably changes and is enhanced following the flow of society's economic activity. It includes various types of activity with the primary purpose of making a profit (Tuovila, 2021). Yet, how exactly do people know that their company is making a profit and by how much? There is one formula that is constantly being used to let financiers know the profit status that they gained throughout their business activity. The method is called the net income formula. Succinctly, net income or “net profit includes all of the costs and expenses that a company incurred, which are subtracted from revenue in a specified time (Murphy, 2021). In detail, the formula is written as:
NET INCOME = Gross Profit — Operating Expenses — Other Business Expenses — Taxes — Interest on Debt + Other Income.
Net income is important because it shows the company the amount of profit for the period when taking all aspects of business into account. Since net income sits at the last line of the income statement, it is also often called the bottom line (White, 2021). Besides showing profit, net income can also serve as a basis for companies, shareholders, and prospective investors to make other calculations when assessing a business’s overall condition, such as earning per share (Marketbeat, 2019). Research conducted by Jordanian scholars also found that current net income has more predictive power for future income and future comprehensive income relative to current comprehensive income for Jordanian companies listed on the research paper (Bataineh & Rababah, 2016). The scholars concluded the matter by using multi-regression analysis, and they found that current net income was proven to produce a higher adjusted R-squared and higher F-value with future net income and future comprehensive income than current comprehensive income, indicating greater degree of association.
Source: http://dx.doi.org/10.6007/IJARAFMS/v6-i2/2077
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Image showing net income as the bottom line.
But net income can only be used with some caution. Despite the predictive power, net income is still retrospective and reflects what has happened in the past so it cannot fully guarantee the future. Moreover, theoretically, it is possible for the net income to be manipulated in many ways such as overstating the revenue or understating expenses (Marketbeat, 2019). Doing so would violate the Security and Exchange Commission (SEC) rules and can be considered as potential fraud. A scandal erupted in 2001 involving an energy company based in Houston, called Enron. In the Enron scandal, accountants let Enron book more revenue than they earned and kept debt and losses off from balance sheets (Cabral, 2020). In the end, 21 people were convicted for the crime and 4,000 employees lost their jobs following the company's bankruptcy (Cohn, 2019).
To prevent such fraud, the net income should be evaluated based on the company’s financial statement in a few recent years instead of the current years only. It is also useful to compare a company’s financial performance with other similar companies within the same industry. Not only that, performing frequent and unannounced controls for a company is also needed to prevent fraud scandals (Dimitrijevic, 2015).
The net income formula is not only useful for big companies. Everyone can make use of the net income formula when conducting financial activities in everyday life, such as balancing monthly income and expenses, leading to financial balance and stability.
References
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Bataineh, A., & Rababah, A. (2016). Comprehensive Income and Net Income, which is more powerful in predicting Future Performance. International Journal of Academic Research in Accounting, Finance and Management Sciences, 6(2), 114-120. Doi: http://dx.doi.org/10.6007/IJARAFMS/v6-i2/2077
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Cabral, C.(2020, August 6). What Did Enron Do Wrong? 4 Reasons They Failed. Shortform. https://www.shortform.com/blog/what-did-enron-do-wrong/
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Cohn, S. (2019, March 23). Former Enron CEO Jeffrey Skilling wants back into the energy business. CNBC. https://www.cnbc.com/2019/03/23/former-enron-ceo-jeffrey-skilling-wants-back-into-the-energy-business.html
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Dimitrijević, D. (2015). The detection and prevention of manipulations in the balance sheet and the cash flow statement. Ekonomski horizonti, 17(2), 137-153. DOI:10.5937/ekonhor1502137d
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Murphy, C. (2021, Juny 4). Gross Profit vs. Net Income: What's the Difference?. Investopedia. https://www.investopedia.com/ask/answers/101314/what-are-differences-between-gross-profit-and-net-income.asp
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Marketbeat. (2019, January 8). Why Net Income is Important to Investors.
https://www.marketbeat.com/financial-terms/why-net-income-important-investors
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Tuovila, A. (2021, July 10). Business Activities. Investopedia.
https://www.investopedia.com/terms/b/business-activities.asp
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White, C. (2021, May 27). Operating Profit vs. Net Income: What's the Difference?. Investopedia. https://www.investopedia.com/ask/answers/122414/operating-profit-same-net-income.asp