Understanding your Numbers for Success!
Credit Enablement Manager
Bank of America
Many small business owners may not know the difference between gross and net income — two critical metrics for assessing business performance. Understanding this distinction is critical to understanding your business’s financial health.
What is gross income?
Gross income is best defined as the total revenue derived from the sales of goods and services during a specified period with the direct costs of making the product or providing the service (i.e., cost of goods sold) subtracted. Also referred to as “gross earnings” or “gross profits,” gross income is the total reflected in the “gross income” section of a profit and loss statement.
Say a business sells $350,000 worth of a kitchen gadget it manufactures over the course of three months, and the cost of goods sold is $50,000. That translates to $300,000 in gross quarterly income.
What is net income?
Net income is the total amount of profit a company makes over a given period after expenses are deducted.
Businesses can calculate their net income over a designated period using the following formula:
Net income = (gross revenue during a given period) - (total expenses)
Often referred to as the bottom line, it reflects the profit remaining once all expenses and costs have been accounted for and subtracted from revenue.
Also referred to as “net profit,” “net earnings,” or “profit,” net income is often a key indicator of how well a business is managed. Moreover, it can be a useful metric for investors in determining a company’s overall profitability and potential long-term value and return on investment.
Expenses can fall into several categories, including:
Direct expenses, such as costs related to goods and services (e.g., raw materials, labor, shipping, production facilities, etc.)
Indirect expenses, such as overhead and operating costs (e.g., fees for accountants and lawyers, administrative expenses, insurance, utilities, etc.)
Once calculated, net income can be either a positive or negative number. In other words, if a company brings in more gross revenue than expenses, the net income is positive. If total expenses exceed revenue, the net income is considered negative, which is known as a net loss.
Using gross versus net income in making business decisions
Both gross and net income can be useful in making business decisions; however, you will want to rely on them as a guide in different circumstances.
In managing a business, companies often use gross income to:
Evaluate whether your cost of goods sold is well controlled
Determine whether the pricing of your products or services is sound and allows you to properly pass along the cost of goods sold to the consumer
Understand a business’s profitability
On the other hand, net income is useful as a strategic business tool for the following:
Assessing the financial health and determining the overall profitability of a business over a period of time
Calculating a company’s profit margin or its net income as a percentage of gross revenue (i.e., a company’s true profitability for every dollar in sales)
Evaluating the net inflow and outflow of dollars from your business
Demonstrating your business is sound when applying for a loan
Making strategic budgeting and price decisions based on revenue and expenses
Identifying areas for cost cutting to bring the business to profitability
Many owners will look at both their gross profit margin (the revenue they are bringing in after they subtract the cost of goods sold) and their net profit margin (what is left after they also subtract other expenses) to evaluate how sustainable their business is.
If the gross margin is trending downward, the cost of goods sold may be too high.
If the net margin is declining, you may be spending too much on other costs in the business.
Every industry is different, and it can be helpful to see how your business’s financial performance stacks up against similar ones in your industry. Talking with a good small business accountant or consulting a market intelligence tool such as Vertical IQ can be very helpful.
As a small business owner, understanding the distinction between gross income and net income is vital for assessing the financial performance of your business. These numbers tell you and potential backers how viable your business is, both now and for the long term.