Tax and Finances are something we all dread but have no escape. A good analysis of your financial position can help you make better financial decisions. Net Income is one of the most important tools for understanding your personal or your business’s financial health. Net income can be calculated for both your personal finances and for your business. This article will help you understand how and why you must calculate net income for both.
Net Income for Businesses
What is Net Income?
Net Income (NI) in the context of a business refers to the total amount left over after deducting all expenses. Also known as net profits, this number reflects the actual performance of your business. Before we look at how to calculate your net income, let’s understand a few key terms:
- Revenue: Revenue is the total money accumulated by the company over a fiscal year. This includes everything like sales, interest, revenue from patents/copyrights etc.
- Gross Income: Gross Income is the amount left from the revenue after deducting the cost of goods sold (COGS)
- Expenses: These include all the money that goes out of the company/business in addition to the gross income. This includes things like taxes, legal fees etc.
Once you have all these figures ready you can move on to calculate the net income of your business. Net income can be calculated quarterly, bi-annually, or yearly whichever suits your needs.
How Should Businesses Calculate Net Income?
Calculating Net Income is quite easy once you have the numbers in place. The formula is:
Net Income = Total Revenue – Total Expenses
Let’s take an example to understand.
Say your revenue from sales for the year was $40,000, you earned interest from investments of $ 2,000 and earned revenue of 3,000 dollars from copyright licensing.
So, your Total Revenue = 40,000 + 2,000 + 3,000 = $ 45,000.
Let’s move on to expenses. Say your COGS is $20,000, you run a payroll of $5,000 and pay taxes worth $ 6,500.
So, your Total Expenses = 20,000 + 5,000 + 6,500 = $ 31,500.
Now finally, your Net Income = 45,000 – 31,500 = $13,500
A positive Net Income means your business earned a net profit, a negative indicates a net loss.
Benefits of Calculating Net Income
While calculating your net income is mandatory for tax purposes, these are some essential benefits of calculating net income:
- Business analysis: Revenue can be a very deceptive figure, it is the net income which actually depicts the health of your company. Net income helps you understand the profitability of your business. A good analysis of your net income will help you in making positive changes to grow your business. You can also calculate the profit percentage, by multiplying your net income with net sales revenue and then divide it by 100. This percentage helps you to calculate your overall growth over the years.
- Investments: If you are looking to grow your business and get investors, calculating net income is mandatory. All investors are going to ask for your net income statement, in order to judge the health of your company, before investing.
- Tax Filings: Net Income calculation is necessary for certain tax filings as well. For example, small business owners who have a net income of $ 400 or more have to pay Self Employment Tax. The form of Self employment tax requires you to fill your net profits.
- Competitor Performance: You can use the net income of your competitors to get a better understanding of how you are doing in the market. You may be earning more revenue than your competitors but if you are not making more net profits, this will affect your business massively in the long run. So use the income statements of your competitors to analyse their net income and investments.
Personal Net Income
What is Personal Net Income?
Personal Net Income refers to the income earned by you after all deductions and taxes. If you work for a salaried job, your personal net income is your Take-at-home Paycheck. But with the growing age of freelancing and side hustles, Americans today rarely have a single salaried source of income. This is why it becomes necessary for all individuals to calculate their own net income. Let us first understand a few important terms:
- Active Income: Active income includes those sources of income where you are actively working for. This includes your salaried jobs, freelance gigs, income earned through selling old items etc.
- Passive Income: This is the income you derive from your investments like rents, interest, shares etc. Your Net Income calculation would include both Active and Passive income.
- Deductions: All additional amounts which are deducted from your income apart from taxes are called deductions. These may include health insurance premiums, retirement plan contributions,401(k) plans etc. Most deductions are pre-tax and help you in reducing the amount of taxes you pay. But deductions of your insurance premium and retirement plan contributions may depend on your policy and generally vary from person to person.
How to Calculate Individual Net Income
The formula is pretty much the same.
Personal Net Income = Total Income – Tax and Other Deductions.
For example, if your income from Freelancing is $ 500 and you earn $ 200 from selling your old clothes online, your Total Income = $ 700. Since you are self-employed, this income would be taxable under Self Employment Tax. This tax includes contributions to Social Security and Medicare. Self Employment Tax is set at 15.3%, which comes down to $107 dollars roughly in this case. Additionally, say you pay $ 40 dollars/month for insurance.
So, your Net Income = (500+200)- (107+40) = $553. This amount reflects the total sum of money available with you to spend on your own needs.
In case you are struggling to calculate your taxes and consequently your net income, there are many websites available online, which will calculate it for you for free, in no time
- Budgeting: Budgeting is very important for staying within your financial limits and also ensuring to save for emergencies. Net Income helps you understand your budget better. You will have a clear idea of exactly how much amount you have to spend, in order to allocate it in a better and more resourceful manner. Net income will also help you understand if your current job is providing you with enough returns on your labour.
- Future planning: Since net income provides you with the income you are free to spend by yourself, this helps you in calculating your future needs. If you are looking to pursue college or start a family in the future, calculating net income is going to be the first step towards being financially prepared for it.
- Loans/Credits: All banks are going to ask for your net income on any loan application. So this calculation is just unavoidable.
Net Income calculation may seem like a tedious process but if you get your basics right it will not take you a lot of time to calculate. Plus it offers you tremendous benefits. So use it to calculate and understand your finances better. Even if you hire an accountant for yourself or your business, this will help you understand their work better because ultimately you are going to be making all financial decisions so knowing the nuances of your net income is always going to help make better decisions.