How to determine net income from a balance sheet: Formula and examples
Laura Tien
October 29, 2024
Calculating your net income based on the numbers in your balance sheet or from your income statement will allow you to accurately assess business performance. In this article, we’ll take a look at why net income is important, how the net income formula works and how it relates to other financial metrics. Then, we’ll discuss how to avoid common mistakes as well as how to improve your net income.
What is net income and why is it important?
Net income, otherwise known as net profit or net earnings, is the total amount of money your business retains after you’ve deducted all expenses from your revenue. Typically, you would find net income on your income statements, however, there are workarounds to figure it out from your balance sheet.
Net income is crucial for assessing business performance because it provides the most complete image of your finances. You can refer to your net income to make key decisions such as whether to reinvest profits as retained earnings for growth, or implement cost-cutting measures when profitability declines. This data can help you set realistic goals and allocate resources effectively.
Furthermore, net income plays a vital role for businesses looking to get external investment. When evaluating your ability to generate future returns, investors tend to look at your net income as well as other metrics that net income directly impacts such as the price-to-earnings (P/E) ratio.
How does net income differ from gross income and operating income?
Net income differs from gross income and operating income. Gross income is the profitability after direct production costs or the cost of goods sold are deducted from revenue.
Gross Income = Revenue − COGS
Operating income is the profitability from core business operations but excludes interest and taxes.
Operating Income = Gross Income − Operating Expenses
Finally, net income is the profitability after all expenses, taxes and interest are subtracted.
Net Income = Operating Income − Taxes − Interest Expenses + Other Income
Key components of a balance sheet
The balance sheet gives you a snapshot of your company’s financial position at a single point of time. It consists of three key components: assets, liabilities and equity.
- Assets: Resources you own that provide future benefits. E.g. Cash, accounts receivable, inventory, equipment and property.
- Liabilities: Obligations you owe to external parties. E.g. Accounts payable, loans, wages owed and bonds.
- Owner’s Equity: Assets minus liabilities. The amount the owner/s can claim in a business. E.g. Retained earnings, money invested by the owner and stock.
As you can see, net income isn’t shown on the balance sheet. Instead, it’s shown on the income statement which details your financial position over a period of time rather than at a single point. The income statement details revenues, expenses and net income. Changes in net income will influence asset and liability figures on the balance sheet. Similarly, net income will influence retained earnings.
How to determine net income from a balance sheet
Even though net income isn’t directly found on the balance sheet, it does reflect the impact of net income indirectly through retained earnings. The balance sheet shows the cumulative effect of net income over time, as each period’s net income flows into retained earnings and impacts the company’s equity.
To estimate net income using the balance sheet, follow these steps:
- Find retained earnings for the current period and the previous period: Identify the ‘Retained Earnings’ in the equity section of your current and prior balance sheet.
- Calculate the change in retained earnings: Subtract the previous period’s retained earnings from the current period’s. This will reflect the retained profit or loss over the period.
- Identify any dividends paid: Check to see if any dividends were distributed during the period. Find this in financial statements or company disclosures.
- Calculate net income: Add dividends paid to the change in retained earnings to estimate net income.
Net Income = Current Retained Earnings − Previous Retained Earnings + Dividends Paid
OR
Net Income = Change in Retained Earnings + Dividends Paid
Walkthrough with an example e-commerce business
For example, if you wanted to find your net income over the past year for your e-commerce business, Shop Haven, you would first identify retained earnings from the end of Year 1 and end of Year 2.
Let’s say these were $17,000 and $28,000 respectively. The change in retained earnings would be $11,000.
Then, suppose Shop Haven paid $2,000 in dividends to shareholders during Year 2, we would need to add this back to find the total net income for the year.
Therefore, to get an estimate of your net income based on figures you can find on your balance sheet, you would add $2,000 to $11,000, totalling $13,000.
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Limitations of using the balance sheet to find net income
Though there may be situations where only the balance sheet is available, it’s important to note that there are many limitations with determining net income without your income statement. Here are some of the key reasons why using the balance sheet may limit your ability to accurately understand profitability.
- Absence of income data: The balance sheet doesn’t provide an accurate picture of revenue or expenses, both of which are essential for accurately calculating net income.
- Missing expense details: Important details, like depreciation and tax expenses, which impact net income, are not fully visible on the balance sheet.
- One-time items: Extraordinary gains or losses (such as asset sales) that can impact net income aren’t obvious on the balance sheet.
- Inventory and COGS: Inventory levels affect the cost of goods sold (COGS), a crucial component of net income. However, only inventory values (not COGS details) appear on the balance sheet, complicating income estimation.
Using accounting software to track and calculate net income
Accurately tracking and calculating your net income becomes easy when you implement a cloud-based accounting software in your business. Tools such as QuickBooks Online, Xero, Sage or MYOB can streamline your financial management and help to ensure your records are precise.
These software solutions can generate income statements with the click of the button, pulling data from various accounts such as sales, expenses and retained earnings. You can easily review trends in net income over time by using reporting features.
To make sure that the data used to calculate net income is accurate, you can use a variety of automation tools. These reduce the risk of human error and save you from having to do manual data entry. For example, you can use an e-commerce or POS system accounting integration to automatically sync sales data to your accounting system.
Amaka’s accounting integrations are available on a completely free plan. If you have a Shopify store for instance, it will sync transactions to your accounting software either on a daily basis or on a per order basis. Then, it will automatically match these transactions to your bank feed to make the reconciliation process lightning-fast.
Schedule a walkthrough of a relevant integration below with one of our team members to see how much time you could save.
Strategies to improve your net income
Adopting strategies to improve your net income is essential for the sustainability and growth of your business. Focusing on revenue growth, operational efficiency and tax optimization can help to enhance profitability and build a solid financial foundation.
Your business can increase revenue through a variety of methods. For example, you can explore new market opportunities, expand product lines and boost your marketing efforts to attract more customers. Separately, you can look to implement different pricing strategies. However, be careful to strike a balance between increasing revenue and maintaining sales volume.
On the flip side, streamlining processes, reducing waste and leveraging technology can help to lower your costs. Review your workflows on a regular basis to identify inefficiencies and opportunities for optimization. Additionally, seek opportunities to renegotiate contracts with your suppliers, switch to more cost-effective materials and automate repetitive tasks.
Last but not least, a commonly overlooked part of improving your net income is optimizing your taxes. We always recommend working with a tax professional to help you understand different tax planning strategies and how to maximize deductions.
Key takeaways on determining net income
Ultimately, while net income can be found directly on the income statement, it can also be estimated using the balance sheet. However, it’s crucial to recognize the limitations of relying solely on the balance sheet since having an accurate understanding of net income is so crucial to business decisions. Being able to precisely track your net income and implementing strategies to improve it is crucial to your business’s long-term success.