Preliminary net income is an important financial metric that represents a business's finances after accounting for all expenses and taxes. Simply, it’s the amount of money that is available to the business once all expenses have been paid.
Let’s kick off this topic by examining how you calculate Net Income and then delve into what this figure means for small business owners like you.
Which financial statement reflects net income?
The income statement or profit and loss statement reflects your company’s financial position by accurately showing the NET INCOME.
Firsty, calculating net income is dependent on the accuracy of the financial transactions you record in the general ledger. This is why accurate monthly bookkeeping is so important - even for a small business.
The Net Income formula looks like this:
Sales Revenue - Cost of Goods Sold = Gross Income (Gross Profit)
Gross Profit - Operating Costs = Operating Income
Operating Income - Depreciation - Interest = Taxable Income
Income before taxes - Income Tax = NET INCOME (NET PROFIT)
Let’s take a look at a practical example to help you understand what this figure represents.
Net Income for a Tech Start-Up
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A tech start-up in its first year of business is developing an innovative app that allows users to purchase trees and allocate them to a specific area to be planted by government agencies participating in the ‘A Tree for Life’ initiative. The initial investment comes from venture capitalists.
Using financial data from the company’s records, the preliminary net income can be calculated.
Calculate preliminary net income
Data:
Revenues: $20,000 from early adopters.
- Expenses:
Development Costs: $50,000
Marketing: $10,000
Administrative: $5,000
Calculation:
Preliminary Net Income=$20,000−($50,000+$10,000+$5,000)=−$45,000
Even this basic calculation tells a story. The negative net income of -$45,000 shows the high costs of product development and the delayed revenue returns while testing happens.
But what else can be learned from this example? Let’s discuss a few talking points that will be relevant to most businesses when dealing with preliminary net income.
What can we learn?
These figures immediately give some insight into cash flow. We can see from this figure that the business has spent much more than it has received. Although this is normal for a startup in its first year of business, due to development costs, it means that the business does not have a favorable cash flow.
Secondly,, these figures show the need for investment funds and/or an increase in sales to improve the business's financial health. Future spending (operating expenses) will need to be tightly controlled in order for this business to claw back some of the money spent on development.
Now that you understand what this figure looks like and what you can learn from it, we can delve more deeply into the importance of preliminary net income for small business owners.
A deep dive into preliminary net income
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Making sense of your company’s income statement begins with knowing what each component of the net income formula actually shows you. Ultimately, every financial translation you record becomes about an accurate bottom line. Let’s get into it.
Sales Revenue
Sales revenue is the starting point of the net income calculation. It includes all income generated from core operations, such as the sale of goods and services. It's important for businesses to diversify their revenue streams to stabilize income throughout economic fluctuations. For instance, a retail clothing store might increase its revenue streams by offering personal styling services or online sales in addition to in-store purchases.
A brief pause to talk about your bookkeeping practices
At Hall Accounting Company, we have found that it is difficult for small business owners to keep accurate financial records of their business operations without a structured chart of accounts, monthly bookkeeping and regular monitoring of sales revenue. These basics are foundational for working out your company’s profitability and making informed decisions.
If you’ve already recognized the need for a more structured and consistent approach to your bookkeeping, we are happy to set up a consultation with you to discuss your needs.
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Cost of Goods Sold (COGS)
These are the direct costs associated with the production of the goods or services sold by your business. This includes materials and labor costs directly tied to product creation. Managing COGS effectively is crucial because it directly affects the gross profit of your business.
Operating Costs
Also known as operating expenses, they cover all expenses required to run the business (including administrative expenses) that are not tied to production. Reducing these expenses can significantly impact your company’s operating income. This figure is different from preliminary net income because it strips out depreciation, interest and taxes and shows how well you are managing your company's revenue.
Depreciation
Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life. It is a non-cash expense that affects both the balance sheet and the income statement. Understanding depreciation is vital for businesses as it provides tax benefits and affects net income. For instance, faster depreciation can reduce short-term taxable income but may increase future tax burdens.
Interest Expenses
Interest expense arises from borrowed funds, such as loans or lines of credit. It's critical to manage how much a business borrows, as interest can significantly affect the company’s profits.
Income Tax
Based on the taxable income amount (Operating Income - Depreciation - Interest), taxes can vary widely depending on the business structure and location. Effective tax planning can help reduce the tax burden and thus improve net income. This involves making use of all permissible deductions and understanding the timing of income and expenses.
You can never start planning your annual business income tax too soon! Contact us for a free, no obligation consultation and let’s start planning how you can make use of deductions and reducing your tax liability now.
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Preliminary net income matters
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Calculating preliminary net income answers many pressing questions you have as a small business owner. Having this kind of information at your fingertips empowers you to confidently anticipate financial challenges, manage your cash flow and invest in new projects.
It also helps you to gain insight into the effectiveness of your pricing strategies, cost management, and overall operational efficiency. More importantly, it serves as an indicator of financial health for investors and helps you make business forecasts.
Take action now
Don’t let the complexities of financial analysis deter you from getting the financial data you need to grow your business and continue doing what you love. Hall Accounting Company is here to help you not only understand these metrics but to help you take advantage of them.
From setting up efficient bookkeeping practices to strategic tax planning and preparing detailed financial forecasts, our team ensures that your financial needs are met with precision and understanding.
Ready to enhance your financial acumen and secure your business’s future? Contact Hall Accounting Company today, and let’s turn those numbers into growth opportunities.