Understanding Gross Income vs. Net Income

first_imgWhether you’re running your own business or working for someone else, certain metrics are key to understanding how you’re doing financially. Net income and gross income are two numbers that can help you evaluate your business or personal finances. Various people and organizations might need to know your gross income—from your landlord to your accountant.  You’ll need to know your gross income if you’re applying for a car loan, filling out your tax return, or getting a mortgage. Gross income refers to the total amount of revenue you or a business receives in a given year (minus a few specific expenses). Net income, on the other hand, is the amount of income left over after all expenses are factored in. Before you make a plan for your budget, your business or your investments, let’s take a closer look at these two important terms.What is Gross Income?Gross income is the total amount of income that’s achieved by an individual or business in a certain period, usually one year. For individuals, gross income includes wages, salaries, pensions, interest, dividends, and rental income. For businesses, it involves revenue from all sources—basically anything found on the income statement. How you calculate gross income depends on whether you’re talking about an individual or a business. If you’re running a business, knowing your gross income gives you an immediate picture of how well the business is functioning. As an individual, you’ll know exactly how much you’re making.How to Calculate Gross IncomeGross income is worked out similarly for businesses and individuals: by adding the different sums of money you’ve generated during the course of a year minus any costs or adjustments.To calculate your gross income, add income you’ve been paid to money you’ve generated from property rents, stock dividends, and any alimony payments or benefits you’ve received. You’re allowed to deduct certain amounts, such as the interest you pay on your student loans, and certain benefits, to arrive at a figure known as Adjusted Gross Income (AGI)—the amount you’ll be taxed on. For business owners, gross income is calculated by adding together any revenue the business has generated directly from its sales or services. The cost of goods and raw materials along with direct labor costs are subtracted. To find gross income, use the following equation:Sales revenue – cost of goods sold (COGS) = gross incomeGross Income for BusinessWhether you’re selling a physical product or delivering a service, your gross business income is the same calculation, and it tells you about the financial health of your business. The number is often converted into a percentage, known as gross profit or gross margin.For your gross income calculation, you’ll subtract the specific costs that are directly related to creating your product or delivering your service—but not all expenses. The cost of raw materials should be deducted. Overhead costs, though, including wages that aren’t directly related to the goods or services are not deducted.Here’s an example. A clothing company manufactures designer jeans at $110 a pair. They sell 5,000 pairs and make $550,000 in revenue. If the denim they buy to make the jeans costs $45,000, and the tailor’s wages are $42,000, the company’s gross income can be worked out as follows:$550,000 – $45,000 – $42,000 = $463,000Here’s another example:A plumber running his own business charges $50 per hour and works 80 hours a month, generating $4,000. Because he doesn’t have any direct costs besides the petrol for his car ($120), his gross monthly profit is $3,880.What’s important to note is that direct labor costs such as the wages of those people manufacturing the goods should be deducted. But rent, utility bills, and administrative costs of running the business should not.Gross Income for an IndividualWhen calculating gross personal income, you should add your wages (including any bonuses and tips you receive) to income from properties, shares, alimony, pensions, and taxable benefits. You can find the amount you’re taxed on by subtracting any above-the-line deductions such as student loan interest.It’s worth noting that some sources of income are not taxed—such as insurance payouts, inheritances, and gifts. While you won’t need to include these when calculating your gross personal income for your tax return, you might in other circumstances, such as when you’re applying for a loan.Here’s an example. Jane works for a wildlife charity and her salary is $3,000 per month. She rents out her spare room on Airbnb, which gives her an additional income of $900 per month. She then deducts the interest on her student loan ($150), which is an above-the-line deduction, to arrive at a gross monthly income of $3,750.($3000 + $900) – $150 = $3750.What is Net Income?Net income, also called net profit, is the income remaining after expenses are deducted from the total revenue. In other words, net income is the amount you make after factoring in all of your costs. Like gross income, net income can be calculated for your personal finances or a business.For individuals, net income allows you to see how much you’re taking home after you factor in expenses necessary to earn the income. For example, you’d deduct the cost of commuting to work, such as your gas or bus fare. Other expenses associated with work, such as buying a uniform or paying income taxes, should be deducted to know your net profit.The net income of a business is the company’s revenue minus costs. Subtract all expenses including everything from taxes and staff salaries to inventory purchases and utilities. Calculating the net income of a business allows you to see how profitable it is. After deducting expenses, you’ll know how much the company is actually earning. A company with a positive net income turns a profit. If the net income is negative, the company is operating at a loss. By knowing the net income, investors can better understand how a company is performing. It’s a key component of analyzing a stock for purchase.How to Calculate Net IncomeTo calculate your personal net income, subtract your expenses from your total revenue for the year.Formula: Net Income = Total Revenue – Total ExpensesFor example, say Jennifer’s jewelry company brought in a revenue of $50,000 this quarter. With her business expenses, including operating costs, employee salaries, inventory, and taxes at $20,000, her net income is $30,000.Total Revenue ($50,000) – Total Expenses ($20,000) = Net Income ($30,000)Jennifer’s jewelry company made $30,000 in profits this quarter, which she can invest back into the business.You can find net income at the bottom of an income statement, as shown in the example below. Expenses are broken down into categories like operating costs and taxes.Net Income for a BusinessNet income is usually easy to find on a financial statement and is an important factor when making an investment decision. Compare the net income with competitor companies, along with other factors—such as price-to-earnings ratios and debt-to-equity ratio—to determine if you should invest.To achieve a solid net income for your business, review your operating costs and aim for the largest possible profit margin. If you can lower expenses, such as staffing costs, while maintaining the same gross income, your profit margin will be higher.Net income can also help you calculate a company’s price-to-earnings ratio—which is helpful for investors. The price-to-earnings ratio (P/E ratio) measures a company’s current share price against its per-share earnings. In general, a high P/E ratio means investors are expecting higher growth in the future. If a company doesn’t have a P/E ratio, they’re losing money.Net Income for an Individual Personal net income refers to the income you’re left with after deductions for work-related expenses like health care premiums, taxes, and pre-tax retirement contributions. Your annual net income is the amount you take home in the year after subtracting the costs associated with earning that money.It’s important to be aware of deductions you might be eligible for when preparing your taxes, such as travel and office costs. Understanding your net income can help you determine where and how to invest your money, such as estate planning and 401k investments. For instance, it might be more beneficial for you to put pre-tax money in a company 401(k) than contribute after-tax money to an IRA.Your gross and net income can impact your taxes and other financial decisions like your investments. The gross and net income of a business tells about its profitability and gives you key insight on whether you should invest. Overall, having a budget and an investment plan ensures you’re making the most of your hard-earned money. Sources:  Intuit Turbo | Investopedia | Investopedia | Smart Asset | The StreetShare this:Click to share on Twitter (Opens in new window)Click to share on Facebook (Opens in new window) RelatedDiscretionary Income and Student Loans: What Does It Mean?August 19, 2019In “Financial Goals”What is a Stipend: Everything You Need to KnowSeptember 5, 2019In “Financial IQ”How Lenders Determine How Much House You Can AffordOctober 15, 2013In “Housing Finances” Post navigationlast_img read more