A Guide to Net Earnings: What Is It and Why Is It Important?
By Indeed Editorial Team
Published April 20, 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Responsibly operating a business requires some familiarity with key accounting terms that appear on financial statements. Net earnings and net income are two concepts you may encounter or apply when tracking cash flows, and you can use them interchangeably. Learning more about net income can help you assess the finances of a business more effectively.
In this article, we answer the question, "What are net earnings?", clarify its difference to net income, explain their importance to financial records, explore the formula you can use when calculating it, identify how to use the formula, and review the different types of earnings and income.
What are net earnings?
Net earnings refer to what's left of a company's total revenue after deducting all of its expenses. Also called net income, net profit, or bottom line, it's a metric used to determine a company's profitability during a particular accounting period. For example, investors might use it to assess how much an organization's revenue exceeds its expenses. Net profit typically appears on the last line of a company's income or financial statement.
Net profit vs. net income
The terms net profit and net income have the same meaning. They both describe how much of a company's income remains after subtracting all business expenses from total revenue. Even though their meanings are the same, they may refer to distinct ideas. While income refers to money made from revenue sources, like sales of goods and services and profits from investments, business analysts can use earnings to compare the profitability of companies in the same industry.
Why is net profit important?
Experts generally consider net profit to be an indication of a company's overall financial health, which is important for the following reasons:
Profitability and purchasing power: Net profit can offer you an insight into a company's profitability. With high net profit, a company can compensate investors, pay dividends to shareholders, or start new projects, which can assure investors to invest in the company.
Loans: The higher a company's net profit is, the more likely it is to obtain loans from banks and other lenders. A high net profit can help ensure that the company has the capacity to pay the loan back.
Revenue growth: Calculating net profit is a way for a company to monitor how much money it's making. It can then use this information to determine how to generate higher revenue.
Planning and budgeting: Net profit can help a company strategize for the future, which is often important in the early years of a business, when the company may not have a high-profit margin. The net profit can indicate how much revenue to expect and how long the business can sustain running at a deficit.
Tracking costs and expenses: Calculating your net profit typically requires deducting your taxes and all other costs. As such, the calculation can help monitor and identify expenses that may reduce profitability or purchasing power.
Formula for calculating net profit
Total revenue usually represents all money earned from product sales and other income sources like investments, while total expenses include the cost of goods sold, operating expenses, income taxes, interest expenses on loans and debt, depreciation of fixed assets, and general and administrative expenses.You can calculate a company's net profit using the following formula:
Net profit = total revenue - total expenses
How to use the net income formula
Consider these steps when using the net income formula:
1. Calculate your total revenue
Total revenue refers to the total income that a company generates through the sale of its products. To calculate a company's total revenue, first determine how many units of each good or service it sold within a specific period and their individual prices. You can then determine the total revenue by multiplying the number of sold units by the average price per sold unit and adding income from other sources, such as investments.
2. Calculate your total expenses
After calculating the company's total revenue within a certain period, you can then add all expenses within the same time frame. Include both operating and non-operating expenses to get the total expenses. Operating expenses directly relate to the company's activities. They often include the cost of goods sold, which is the value of all sold goods over a specific time, administrative fees, rent, and other similar expenses. Non-operating expenses rarely relate to the company's activities and include interest on previously made loans, losses on past investments, and taxes.
3. Use the net income formula
After determining the total revenue and expenses, you can calculate net income by inserting the figures into the net profit formula. You can start by writing the organization's total revenue and then subtracting all expenses and costs from that number, including taxes. The resulting number is the company's net income.
Types of earnings
Here's a list of types of earnings to help develop your understanding of financial statements:
Earnings per share
This metric indicates the profitability of a company relative to a single share. To get this figure, you can divide the company's total earnings by the number of shares outstanding. A high earning per share signifies profitability and can attract investors. Some companies may adjust their calculations to accommodate unusual events that, if left unaddressed, can have a misleading influence on earnings per share. Companies usually label these events as "extraordinary items" and disclose them on financial statements.
Sometimes known as the price multiple or earnings multiple, the price-to-earnings ratio measures a company's current share price in relation to its earnings per share (EPS). Investors and analysts often use this metric to compare a company's share value with that of another company operating in the same market or industry or compare the company's historical performance. When a company has a high price-to-earnings ratio compared to similar firms in its industry, it can suggest the company has an overvaluation. Conversely, undervalued companies usually have a low price-to-earnings ratio.
The earnings yield is the earnings per share for the most recent 12-month period divided by the current market price per share. As the inverse of the price-to-earnings ratio, it indicates the percentage of a company's earnings per share. This metric can allow investors to compare expected profits from an investment with interest rates like the treasury yields, which are the total earnings on treasury notes, bills, bonds, and inflation-protected securities. When the earnings yield is higher than the treasury yield, it suggests that one may get greater returns from investment in a company than from investing in assets like bonds.
Retained earnings refer to the amount of net income a business has left after paying dividends to its shareholders. You can calculate it by deducting total dividends paid from the company's historical profits. Companies often retain earnings for investment purposes. They typically spend these funds on new assets purchases or buying back stock. A company's management often decides what percentage of its profits to retain and what percentage to share among shareholders. Growth-focused companies typically favour retaining earnings to bankroll expansion. Retained earnings appear in the shareholders' equity section of the balance sheet.
Types of income
Here's a list of the different types of income to consider when reviewing financial statements:
Also known as gross profit or gross margin, gross income indicates how much money a company has made after deducting the direct costs of making its products or providing its service. To calculate it, you can subtract the costs of goods sold (COGS) from revenue. Note that this metric accounts only for COGS. It doesn't cover other costs related to selling activities, administration and taxes, and other running expenses. Gross income indicates how efficiently a company turns labour and materials into products. Although a company may sometimes include it in its income statement, it's not a requirement.
Net income refers to a company's profit after subtracting all expenses from total revenue. This metric involves all expenses, including overhead costs, such as general and administrative expenses. It may also include expenses like income taxes, wages, rent, utilities, and depreciation. Aside from detailing income made from selling products, net income also includes profits from investments or sales of assets. Investors are usually careful when assessing net income, as companies can sometimes calculate revenue prematurely before all these expenses have occurred or conceal significant expenses.
Investment income is money made from the owning or sale of assets. This money typically includes interest payments, dividends, income from real estate, capital gains, and the sale of certain forms of commodities, such as gold coins. Separating investment income from earned income is crucial in accounting because the government taxes the two types of income at different rates. Investment income usually contributes to total net income.
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