If you're running a small business, understanding your finances is key — including knowing the difference between gross income and net income. It's not always straightforward, but it's essential for making smart decisions.
This guide will help you understand these terms, how they're calculated, and why they matter to your business's success.
What is net income?
Net income, often referred to as "the bottom line," represents a company's profit after all expenses — operating expenses, taxes, interest, depreciation, and other costs — have been deducted from its revenue. In simpler terms, net income is the leftover profit after all the bills are paid.
A small business can calculate its net income using this simple equation:
Net Income = Total Revenue - Total Expenses
Once you know how to calculate it, it's important to understand how net income provides a clear picture of a business's profitability and financial health. It indicates whether a business is generating more revenue than it is spending. For example, if a bakery earns $10,000 in revenue but spends $7,000 on ingredients, rent, and wages, its net income would be $3,000.
This metric aids in decision-making, strategic planning, and assessing overall success. Net income also plays a vital role in securing funding, as it highlights a business's health and growth potential to investors and stakeholders.
[Read more: How to Create a Financial Projection in Excel]
Net income also plays a vital role in securing funding, as it highlights a business's health and growth potential to investors and stakeholders.
What is gross income?
Gross income represents a company's total revenue before any deductions are made. It's the initial figure reflecting the total earnings from sales or services provided. Calculating the gross income typically involves subtracting the cost of goods sold (COGS) from total revenue. In other words, gross income is expressed as the following equation:
Gross Income = Total Revenue - Cost of Goods Sold
Understanding your gross income is crucial because it reveals how much revenue is left after covering the direct costs associated with generating that revenue. It highlights the profitability of core business operations, separate from other expenses. For example, a clothing boutique's gross income would be the total sales revenue minus the cost of purchasing the clothing items. This metric helps decision-makers assess a business's ability to generate profit from its primary activities, as well as identify trends in pricing and inventory management.
[Read more: What's the Difference Between CapEx, OpEx, and COGS?]
What is taxable income?
Taxable income, as defined by the IRS, is the portion of your gross income that is subject to taxation. It's not simply your total earnings; rather, it's what remains after allowable deductions and exemptions have been subtracted. As a business owner, knowing how to calculate your taxable income is essential to determine how much is owed to the government.
Calculating taxable income involves taking your gross income and then subtracting business expenses, deductions, and any applicable credits. These deductions can range from operating expenses to depreciation.
Accurately calculating taxable income helps with financial planning and complying with state and federal tax laws. Without a clear understanding of what falls under taxable income, businesses risk inaccurate tax filings, penalties, and missed opportunities for tax savings. Because of these potential risks, many small business owners opt to work with tax professionals for personalized guidance.
How do gross and net income affect your budget?
Gross income provides a broad overview of your earning potential. It's useful for long-term financial planning, like setting savings goals or assessing your overall earning capacity. Lenders often consider gross income when determining loan eligibility.
Net income reflects your actual take-home pay. This figure directly impacts your day-to-day budget. Net income dictates how much you have available for essential expenses, discretionary spending, and debt repayment.
An easy way to understand the difference between net income and gross income is to remember that gross income is what you make before taxes and other deductions, and net income is your final profit after deductions.
When budgeting, net income is the main metric you need to know to ensure your expenses align with available funds. While gross income offers a valuable perspective on earning power, net income provides the practical foundation for managing your finances.
[Read more: How to Calculate Cost of Equity for a Small Business]
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