The net income of a company is its profit. The terminology is influenced by its source, which is the company's Income Statement. This statement shows Income at the top, namely the company's sales (also called revenues and, in British usage, turnover). All sorts of items are then deducted from this income—costs for raw materials, wages, supplies, purchased services, rents, lease payments, executive salaries, marketing expenses, management overhead, and depreciation. At each point the subtotals are less and less. At the very end, taxes are deducted. The last line of the income statement finally shows what is left over: Net Income. This, of course, is the company's profit, also called after-tax income. Wall Street calls this number "earnings after tax" or "earnings" for short. The designation is deceptive because most people think of earnings as their pay—and costs come after that. In corporate finance, earnings are "the bottom line."

Net income is typically tallied once a month for tracking purposes. In publicly traded companies it is published quarterly and annually. It can be negative, indicating that costs have exceeded revenues. It can be zero. In that case income and costs were exactly the same and the company has simply broken even.

While net income is the most important indicator of a company's profitability, it should not be confused with cash profit—unless the company accounts on a cash basis. Most companies use the accrual method of accounting. Under that system, income is "booked," i.e. recorded, at the time when a sale is made—not when payment is received. Similarly, costs are recorded when purchases are made—not when payments are sent out. Under certain circumstances, a company may show high profits and yet have no cash on hand. The timing differences between bookings and cash receipts may also work the other way: a company may have ample cash and be experiencing losses on the books. This difference between profitability and cash flow is important because in many situations, such as borrowing, getting a lease, or trying to sell a company, the lender, lessor, or buyer will be interested in cash flow above all.

Subcategories

Most income statements will show four different income figures. The first is "operating income," common in companies that manufacture products. Operating income is what is left over from sales after production expenses have been subtracted but before overhead expenses have been applied. Next is "pretax income," the amount the company has left over after paying overhead but before deducting taxes. Reporting of this figure is optional under the accounting rules. The third is "income before extraordinary items," which is equal to ordinary revenues less ordinary expenses. Extraordinary items include any non-operating gains or losses that are unusual in nature and infrequent in occurrence. They are separated from ordinary income in order to avoid confusing the readers of income statements. Reporting of this figure is mandatory whenever there are extraordinary items to be included.

The fourth and final income figure shown on an income statement is net income. It is the difference between total revenues and total expenses for the period, including taxes and extraordinary items. Net income always appears as the last figure in the body of the income statement. Its reporting is mandatory. Corporations (but not sole proprietorships or partnerships) are also required to divide the net income figure by the number of shares of stock outstanding in order to report the earnings per share (EPS) for the period.

Ratios

Net income is used in the calculation of various ratios that act as short-hand for evaluating a company's performance. Profit as a percent of sales is the most common measure. On average, profit is 5 percent of sales, and the business owner will watch this figure to see if he or she is "average." The measure is also called return on sales. Return on equity is also calculated by dividing the average share price by earnings-per-share—and the higher the better. To be sure, a high return will attract stock purchasers who, bidding up shares, will thus lower the return. Much used is the price-earnings (P/E) ratio, calculated by dividing share price by earnings-per-share. This produces a "multiple." If the shares are selling for $40 and earnings-per-share are $2.50, the P/E ratio is 16, suggesting that investors are willing to pay $16 for a dollar of earnings.

BIBLIOGRAPHY

Heintz, James A and Robert W. Parry. College Accounting. Thomson South-Western, 2005.

Pratt, Shannon P. Robert F. Reilly, and Robert P. Schweis. Valuing a Business. Fourth Edition. McGraw-Hill, 2000.

Warren, Carl S., Philip E. Fess, and James M. Reeve. Accounting. Thomson South-Western, 2004.

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