When it comes to evaluating income, you typically look at gross income and net income. These two numbers have some important differences to be aware of but can sometimes be confusing to understand. As an investor, these metrics can provide insights into a company's profitability as well as your own earnings.
Gross income vs. net income: At a glance
Gross income and net income are two different metrics you can use to evaluate a company's profitability. These numbers are useful when evaluating your own personal finances, too.
Gross income is higher than net income and includes total revenue or income, whereas net income refers to net profits after all expenses, taxes, and deductions are taken out. For your personal net income that is typically your take-home pay.
"Gross income is the total cash a business brings in through its sales, also called revenue, and net income is the cash left over after a business pays its bills and taxes," explains James Diel, founder and CEO at Textel .
"Both of these numbers can help investors determine how risky a business investment can be," Diels continues. "If a business makes a load of money but has expenses too high to be profitable, it's a problem. Conversely, if a business keeps costs comparatively low to their income, it doesn't mean much if they dramatically undersell products with lagging growth."
Quick tip : If you're an employee, take a closer look at your paycheck and review all the deductions and taxes taken out to see what your take-home pay or net income is.
What is gross income?
According to the State of California Franchise Tax Board , gross income for companies refers to gross receipts, which includes total revenue from all sources such as sales of goods, provision of services, and any other income producing activities minus costs of goods sold (COGS). Gross receipts refers to all revenue that is earned within a particular tax year without any subtractions.
Gross income is a bit different for individuals, with the IRS stating that gross income includes:
You may be familiar with the term Adjusted Gross Income (AGI), which is used on your tax return.
Gross income is important for businesses and individuals to understand the total of all income sources and sales. It can offer insight into the revenue produced within a year and can be used as a benchmark when planning.
Pros Cons Gross income gives insight into how much a business or individual earns. Gross income of individuals is often used by lenders when making approval decisions. Gross income should increase over time for businesses and be a metric for growth. Gross income doesn't include all expenses, which can take a big chunk out of earnings. Gross income doesn't give the full picture of how much businesses or individuals can actually afford. Gross income doesn't show profitability of a business.
Example of gross income Gross income for a business is calculated by using the following equation: Gross revenue - Costs of Goods Sold = Gross income Let's say a company earns $750,000 from all revenue and total costs of goods (supply, equipment, labor) is $250,000. The gross income would be $500,000. As an individual, gross income typically refers to your annual salary or how much you're paid by your employer. So your gross income may be $75,000 if that's what was agreed upon when you were hired.
What is net income?
Net income is also sometimes referred to as net profit or net earnings (all of these are synonymous) and is what is leftover after you take all total revenue and subtract the total costs of running a business. To calculate net income, you take gross income and subtract taxes and expenses, and include depreciation and amortization as well.
Pros Cons Net income illustrates net profit or net earnings. Net income ffers insight into overall health of a business. For individuals, net income is typically referred to as take-home pay and is helpful when creating a budget. Net income is a number that is used to determine EPS. Net income isn't the same as operating income. Net income doesn't illustrate potential growth of a business. Net income includes total costs and expenses, which may not show patterns of all regular expenses. Individual net income isn't used by lenders to get approved for loans, but is a better metric to show what you can afford.
Example of net income Let's use the examples above with gross income to calculate net income. To calculate net income for a business, you use the following equation: Gross income - total expenses = net income In the previous example, the gross income of the company was $500,000. Let's say total expenses totaled $150,000. The net income would be $350,000 which represents net profits after all deductions and expenses are taken out. Net income as an individual refers to your take-home pay. So you may have taxes withheld, or make healthcare or retirement contributions. So if your gross income is $75,000, after all taxes and deductions you'll make less. Where you live, your tax rate, and tax filing will affect your net income. Using an income calculator or reviewing your pay stub, you might see your total federal, state, Social Security, and disability deductions could equal approximately $20,000, meaning your net income would be $55,000.
How investors use these numbers
Investors can use both gross income and net income to review a company's overall performance. Companies typically create financial statements that share these numbers. Gross income or revenue is on the top line and net income or net earnings is on the bottom line.
As noted above, gross income can show growth and viability whereas net income can show overall profitability after expenses. If there are big gaps between gross income and net income consistently, it might be a warning sign.
"Startups are understood to be unprofitable by most accounting standards because they're reinvesting any profits back into their business," says Asher Rogovy, chief investment officer at Magnifina. "Sometimes this means 'buying revenue' with marketing dollars. Ideally, this revenue recurs and a fresh marketing budget is spent finding new customers. Therefore, it makes sense to analyze gross revenue to measure how quickly the company is growing."
Rogovy also suggests looking at net income for established companies as the primary goal is to pay dividends for shareholders, which are determined from net income.
Investors can review net income on a company's financial statement, which is used to calculate EPS and illustrates how much a company makes for its common shareholders. Earning per share is a company's net income or profit divided by the number of common shares .
Quick tip: You can review a company's financial statements over the past few years to get a clearer picture of growth, profitability, and costs related to the business.
The financial takeaway
As an investor, looking at gross and net income is important when assessing the profitability and growth of a company. It's also a way for you to look at your own personal finance situation with a new lens and help you budget for your expenses and investments with your net income or take-home pay.
Just be aware of the limits of each number. Gross income may show the likelihood of growth but not show the actual cost of running a business. Net income can illustrate net earnings and give you a clear idea of costs, but gives a limited scope when evaluating growth.
These two metrics can be used to evaluate which companies you want to invest with and can offer you a nuanced look at your own personal finances.