Harvard Business School Online explains you can calculate net income from assets, liabilities and equity information available on a company’s financial statements, specifically the balance sheet. You can also find it on the cash flow statement. If no dividends are paid out or investments added by owners, then you can subtract the shareholder's equity of the previous accounting year from the current year’s equity using the balance sheet.
But if a company makes dividend payments to the owners, you must add the value of those payments back to the change in equity to obtain the annual net income. On the other hand, if the business receives additional funds from investors or owners (common for small businesses) in exchange for equity, you must subtract the amount from the change in equity to arrive at the net income value.
Understanding Net Income
The difference between the total revenue and the total expenses, including operating expenses, that the business has incurred or paid for is known as the net income.
Net income is an important metric that determines a company’s profitability. It shouldn’t be confused with gross profit, which only subtracts the direct costs from pre-tax income. Apart from the gross profit metric, other important metrics include operating income, earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation and amortization (EBITDA).
According to Cornell Law School, the net income is derived from the subtraction of all business expenses from all the gross income. It is worth noting that the total income includes monies from the sale of goods and services, as well as investment interest income and earnings from the sale of assets. On the other hand, the expenses subtracted from the gross income include various business expenses, taxes and costs of goods sold (COGS) and even include asset depreciation and amortization and interest expenses.
Usually, net income represents the money left over after the company does business, which can be used for paying dividends, purchasing additional business assets and growing the company. The easiest way to determine it for a given period is to look at a company’s income statement and concentrate at the bottom of the income statement – it’s the bottom line item. However, when additional investments are added or dividends are paid out, it becomes more challenging to do net income calculations, especially when you are just looking at the balance sheet.
Understanding Assets, Liabilities and Equity
Assets, liabilities, and equity are all found in a company’s balance sheet.
Assets are valuable items that a company owns. They include tangible items like cash, real estate and furniture and intangible items like intellectual property. And should the necessity arise, they can be sold for cash. Typically, you can find company assets on the left side of the balance sheet.
On the other hand, liabilities represent the third-party debts that a company owes, notes the University of Florida. They include bank loans, issued corporate bonds, dividends, accrued expenses and accounts payable. While they are necessary for business growth and operations, they must be paid off eventually. Generally, you can find these liabilities on the right side of the balance sheet.
In addition, companies usually include the owner's equity, which the Small Business Administration says represents the share of business that shareholders or company owners can claim. You can determine that value by subtracting all the liabilities from all the assets. However, that amount is not always liquidated and distributed to the investors as dividends. Sometimes, it is used to grow the business.
Calculating Net Income from Assets, Liabilities and Equity
Net income can be derived from the owners' equity since it is part of it. Generally, when a company has higher net earnings, the equity will increase and vice versa.
Below are the various ways you can calculate net income from a company’s assets, liabilities and equity.
When No Dividends Are Paid Nor Stocks Issued or Repurchased
Suppose company XYZ has assets worth $1 million at the end of the 2020 accounting period and $1.2 million at the end of 2021. In addition, it has liabilities worth $500,000 and owners’ equity worth $500,000 in 2020, and $600,000 of liabilities and $600,000 of the owners’ equity in 2021.
Thus, XYZ generated a net income of $100,000, This is assuming no cash injections or distributions were made via reissued or repurchased stock or dividends during that accounting period.
Therefore, the net income formula is the change in assets minus the change in liabilities equals the net income, net profit, or change in owners’ equity.
Change in owners’ equity or net income = 2021 owners’ equity - 2020 owner’s equity.
Net income = $600,000-$500,000 = $100,000.
When the Company Receives a Cash Injection
Suppose company XYZ obtains a cash injection from its investors or lenders to the tune of $150,000 within the 2021 accounting year in exchange for equity. So, the value is included as part of its asset base in its financial reports and will increase the owners’ equity separate from what it earned.
Based on the previous example, you must subtract the $150,000 from the owner’s equity to obtain the true picture of your company’s financial health.
Net income = change in owners’ equity – additional cash investment
$100,000-$150,000 = - $50,000.
That means your company actually experienced a net loss of $50,000. That negative net income was partly hidden by the cash injection.
When the Company Pays Dividends
The moment company XYX decides to pay dividends to its business owners, that amount of money becomes a liability that will reduce the company’s assets and affect the change in owners’ equity negatively.
Net income = change in owners’ equity + dividends
Based on the first example, assuming the financial report was made after dividends worth $75,000 were distributed:
Net income = $100,000 + $75,000 = $175,000.
Therefore, company XYZ did manage to earn a net income of $175,000.
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