Net earnings are what being in business is all about. This is because businesses exist to earn profits, and net earnings state the amount of profit a business makes. More precisely, net earnings measure the amount of money a business gains or loses after all costs are subtracted from sales. The details of the calculation of net earnings are reported on a firm's income statement. Understanding this calculation allows you to interpret the information on the income statement and how the net earnings figure is derived.
Net earnings are referred to as net income on the income statement a business is required to prepare each year (or for another accounting period). Net earnings are defined as gross sales or revenues minus all expenses for the accounting period. These expenses include the direct cost of the products the business sells, operating expenses, non-operating costs and income taxes. This net income formula is thus a series of short calculations that provide business managers and investors a detailed picture of the company's operations and performance. Net income is always the last item on the income statement and is often called the "bottom line".
Stakeholders need to know how much profit a business makes. This simple fact is enough to make net earnings an important piece of information. For owners and managers, net earnings or income is a measure of overall company performance. Potential investors compare a firm's profit from year to year to assess its prospects for growth. Banks and other lenders use net earnings to help determine if a business can repay borrowed money. An increase in net earnings suggests a firm is likely to do well. A decline may alert stakeholders to possible problems.
Net earnings is a base figure that's used to calculate several measures to help stakeholders assess business performance. For example, if you divide annual net earnings by the number of shares outstanding, the result is earnings per share or EPS. Suppose a company has 2 million shares outstanding and net earnings of $3 million. Dividing $3 million by 2 million shares tells investors their investment made $1.50 for each share.
Be careful not to confuse net earnings with retained earnings, which is a figure that appears on a company's balance sheet. The retained earnings formula is the cumulative net earnings since a firm began operations less all owner withdrawals or dividend payments. Suppose a company has $3 million in net earnings and pays out $1 million in dividends for a year. The retained earnings the company keeps to reinvest equal $2 million. This money is added to the total retained earnings on the prior year's balance sheet to arrive at cumulative retained earnings.
The net income formula is gross sales less expenses. This net income calculation involves several steps. Begin with gross sales and subtract the direct costs of purchasing or manufacturing the products the company sells to arrive at gross income. Suppose the Widget Company has $10 million in revenues and $4 million in direct costs. Gross income equals $6 million.
Next, administrative, general and selling costs are subtracted. Collectively called operating expenses, they include things like rent, maintenance, utilities, property taxes, advertising, office expenses and salaries. What remains after these deductions is the operating income. The Widget Company had $3 million in operating expenses. Subtracted from a gross income of $6 million leaves an operating income of $3 million.
Non-operating costs such as interest paid and other costs not related to the company's actual operations are subtracted, along with allowances for depreciation. If a firm has interest or other investment earnings, these are added at this point. The remaining amount is the pre-tax income. Federal, state and local taxes are subtracted to find net income. For the Widget Company, there are $2 million in nonoperational expenses and income taxes. Once these costs are subtracted from operating income, the Widget Company has net income or earnings of $1 million.