NET INCOME AS INDICATOR OF FINANCIAL HEALTH OF BUSINESS
Net income is an accounting term that can be defined as the difference between a company’s total revenues (money earned from sales or investments) and total expenses of money paid to produce goods or services, plus salaries, rent, depreciation, etc.), for a given period of time. Also known as net earnings, after-tax income, or profit, net income is the “bottom line” of the formal accounting report known as the income statement. If a company’s total expenses exceed its total revenue for a certain period, it can be said to have experienced a net loss. If revenues and expenses should turn out to be equal, the company would have broken even.
Net income is one of the most important indicators of the financial health of a business. Some people view the income statement as the most important of the three required financial statements (the others are the balance sheet and the statement of changes in financial position) because it is designed to report the amount of net income and the details of how that amount was earned. The amount of net income for the period represents a net increase in resources (or a decrease if a loss) that flowed into the business entity during that period as a result of operational activities.
Most income statements will show three separate income figures. The first is pre-tax income, which is the amount the company earned before taking taxes into account. Reporting of this figure is optional. The second is income before extraordinary items, which is equal to ordinary revenues less ordinary expenses. Ordinary 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 third 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 income statement, and 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.
In addition to providing information on its own, net income is also frequently compared to other figures in financial ratios in order to provide further information about a company’s financial health. For example, financial analysts often divide net income by total sales in order to find a company’s rate of return on sales. This figure provides a good indication of the amount of profit the company is able to earn for every dollar sales.
Another common ratio examined by financial analysts is return on stockholders’ equity, which can be found by dividing net income by the average equity for the period. This ratio is widely regarded as the ultimate measure of the overall accomplishment.
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