When a company reports earnings, there are two numbers most investors pay attention to -- the revenue and the net income. Revenue is also known as the top line and refers to the company's total sales. Net income is known as the bottom line, and is the amount of profit the company made after paying all of its expenses. This is also known as the company's earnings.
How net income is calculated
When calculating net income, start with the top line, or revenue number. Then, subtract the cost of the revenue in order to calculate the gross profit. Cost of revenue refers to the amount the company paid to manufacture and sell its product. As an example, if you're selling t-shirts, the cost of the cotton you use would be subtracted as part of the cost of revenue.
Next, subtract the operating expenses such as research and development costs and administrative expenses. This will result in the company's operating income.
Finally, subtract taxes, interest, and any other expenses to arrive at the net income.
Let's say that your t-shirt business generated $200,000 in revenue last year. You spent $50,000 on equipment, machinery, and other costs related to making the shirts, which gives you a gross profit of $150,000.
You also had operating expenses of $25,000, which leaves you with operating income of $125,000.
Finally, you had to pay $10,000 worth of interest on an outstanding business loan, and you had to pay $20,000 in taxes. Subtracting these from the operating income gives you a net income of $95,000.
Why it matter to investors
Net income lets you know how much profit the company made after paying all of its expenses. This is significant to you as an investor because this is the amount of money the company has available to pay dividends, repurchase shares, reinvest in the business, or simply add to its cash.
Furthermore, if you divide the net income by the number of outstanding shares, this is how you calculate the widely used earnings per share (EPS) metric, which can help you assess a stock's valuation and calculate several other metrics as well.
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