Financial reporting can be complex, but understanding the types of income can help assess a company's performance. Whether your small business prepares an income statement once a year or once a quarter, you need to know the difference between your net and gross income – two numbers that are vital indicators of the health of a business.
A profit-and loss statement reports the differences between net and gross income. When prepared in a standard format, the income statement is a useful tool for comparative analysis against prior time periods or other industry players. A firm understanding of the difference between revenues (or gross income) and the bottom-line profit (or net income) can enable strategic planning and tax-related decisions.
Understand the difference between net and gross income
Gross income is the total amount earned by a business. It includes all income a business receives, including cash, check and credit card sales and dividends, rental income, and canceled debt. In short, gross income is your total revenue. As a company grows and attracts new customers, gross income should increase.
Net income is the profit generated by a business. It is gross income minus business expenses which can include the cost of goods sold, advertising, rent, utilities, or wages. Depending on the industry, a business expense can be a cost that is common or accepted in the field, or an expense that is specifically helpful or appropriate in a trade or business.
Some other common business expenses include:
- Auto expenses
- Entertaining clients
- Trade shows, conventions, and seminars
- Membership fees for professional associations
- Local business taxes and fees
In addition to revenue factors, net income also takes into account how well expenses are managed. Tax programs offered by the government may assist with increasing net income. For example, local and state tax levels vary, so choosing to locate a business in a certain area could result in a lower tax expense. The IRS also offers many tax credits to qualifying small businesses, including a credit for the production of renewable energy and a credit for companies providing child-care facilities and services.
The relationship between income and cash flow
An analysis of the different types of income should also include an evaluation of cash flow. Income may be reported on an income statement, but if cash or liquid assets are not available to support operations, the company may struggle to cover expenses. A cash flow statement can be prepared to track influx and outflow of cash and provide assurance that sales revenue was collected on a timely basis. Proper cash flow management helps avoid shortfalls created by seasonal sales slumps. For instance, a company selling holiday-themed merchandise may find that a majority of its revenues are earned in one quarter of the year. However, the business still must maintain enough cash on hand to fund year-round operations. Or, a company might report $1,000 in sales on the income statement, though customers only reimburse them for half that amount upfront. Until the balance due is collected, the addition to cash flow will be less than the income reported on the income statement. Using just the income statement for analysis paints an inaccurate picture of the company's overall finances.
Why do differences between net and gross income matter to your business?
Gross and net income are useful tools for business decisions. Gross income numbers indicate the health of revenue streams. Business revenue reported as gross income can be broken down by product to determine success. If gross income for one product in particular is increasing, a shift in resources to capitalize on current sales trends.
Net income shows the amount of profit generated, taking expenses into account. If gross income remains at an expected level, but net income starts to dip, a business can make adjustments by lowering expenses. If expenses are higher than gross income, the income statement will show a net loss.
Net income is also important because it's the number used by the IRS to determine the amount of business taxes owed. Depending on a business structure, net income may be taxed differently. Sole proprietorships and limited liability companies (LLCs) report their net income on the business owners' personal tax returns. S corporations pass through their income to shareholders, who are then taxed at their individual tax rates. C corporations file separate returns and calculate their tax liability as a separate entity, apart from shareholders. A tax or legal advisor can help determine how the best business structure for tax reporting purposes.
Income vs. cash flow as strategic opportunity
Calculating net income offers businesses the opportunity to review both revenue and costs line-by-line, and answer strategic questions like: Are there areas and opportunities to grow? What are the biggest costs?
With a strong understanding of net income, a business owner can begin to test general assumptions and make decisions based on unique data. It could result in decisions to raise prices, for example or cut expenses. It varies depending on business and industry, but in general, strategy decisions should be made after a careful analysis of the income statement.
When you're reviewing gross and net income, inevitably cash flow management will also come into play. To learn more about cash management best practices, download Five Steps to Monitoring and Improving Cash Flow.