If you analyze a company’s balance sheet, you will come across gross income and net income.
Often these two terms are most important indicators of revenue generation.
These are the inseparable part of any income statement.
Only an effective analysis of these two factors will highlight business viability.
They point out the extent of strength and weakness of any specific business.
Their utility is multi-pronged.
You don’t just need these to gauge business growth.
You also need these parameters to file your income tax return.
So how is one different from other?
Or, does it refer to the same in different ways?
Well, these two are relatively different concepts.
They cover different parameters and refer to specific areas of income.
For starters, I will say that you can divide income into two broad categories.
The gross income and net income arise from the same source.
But they effectively refer to different parameters.
This is why an income statement needs both these variants.
You cannot just base your calculation on any one of these figures.
You will have to take a comprehensive view based on both these numbers.
What Is Gross Income?
As the word ‘gross’ refers to, it means the total income.
It normally refers to the total income before tax computation.
So this income does not reflect any type of deduction.
Essentially it is the revenue generated minus the input cost.
So in many cases, it may be referred to as gross profit or even gross margin.
So gross income takes into consideration the entire income received.
In case of multiple sources, your gross income totals the entire amount.
So your source of income may include
- Gains from investment
- Interest on savings
Essentially it covers all possible source of income.
In fact, when you refer to gross income, you can even include illegal income.
Perhaps there is some tax payment that you have avoided.
This will also get included in the gross income projection.
That said there are some income sources that do not get included here.
But these are special exemptions.
They include only a select list of products.
These include the likes of
- Interest earned on bonds issued by state
- Municipal bond interest
- Social security perks.
- Life insurance income
- Certain home sale proceeds.
So all in all, the broad definition of gross income is the aggregate earnings.
Irrespective of the source of the earnings, everything is bunched together.
That gives you a broad idea about the income that you managed to generate.
When you refer to business terms, it gives you a vague idea about profitability.
So keeping a tab of this specific set of earnings is extremely important.
Often it defines the business viability as well as profit prospects.
It can also give you a fair idea about how to expand the business.
How to Calculate Gross Income?
But when you refer to gross income in business terms, there is a set formula.
You can easily calculate this by subtracting the cost of goods from the total revenue.
Gross income = Revenue– cost incurred by sold goods
So in many ways, gross income also becomes a way to calculate gross margin.
Therefore, gross margin becomes a measure of business profitability.
That is exactly why often gross margin becomes synonymous with gross income.
But there is a fine line of difference.
So, gross margin is an expression of gross income, albeit in percentage.
Of course, a gross margin is a relative term.
The same percentage can be referred to as good/bad gross margin.
It primarily depends on the kind of industry the business is catering to.
Let’s take an example.
Supposing I have an IT business and you have an FMCG business.
We may have similar gross income and gross margin percentage.
But while a specific percent may be great for FMCG, it can be subpar for IT.
So a right reflection of gross margin will be a derivation of gross income.
Gross margin= Gross income ÷ total revenue
Different businesses have different margin expectations.
Some businesses are low margin while others are high margin options.
You can then see that calculating the gross income is often an all-encompassing process.
It takes into account all available revenue sources.
So in many ways, it creates a comfortable base to calculate your profitability.
Additionally, the gross income gives you a broad idea of the business sense.
Definition of Net Income
So, how is it different from net income?
What exactly is the difference between gross income and net income?
Net income is a company’s complete earnings, but there is a slight difference.
This income takes into account every deduction or liability that a company has.
So when we calculate the net income, it is minus all the potential payables.
So net income also subtracts every possible cost involved in running a business.
This includes many such costs like
- Tax liability
- Interest cost on loan
- Expense incurred due to running business
- Depreciation cost of machinery
Every element that can impact profitability is deducted.
The net income is calculated only after all of these deductions.
So if my total revenue is ‘X’ and I have ‘Y’ liability, net income is X-Y.
Therefore, net income is a key variable when you are trying to gauge the sustainability.
This is, in many ways, the profit that is left behind after addressing every possible expense.
This is why businesses use this key parameter for calculation the earnings per share.
So this creates a specific profit perspective.
Therefore net income is a far more realistic assessment of profit than gross income.
It reduces the uncertainty to a large extent.
In many ways, it can often be termed as the effective profit or income.
This is particularly important when you are computing income statement.
It gives a clear perspective of the extent of profit.
It will also provide a more definitive direction in taking the business forward.
Ways to Calculate Net Income
So the next question is how do you calculate net income?
Surely the methodology has to be slightly different.
After all, this takes into account a wide variety of costs and expenditure.
As a result, the formula for calculating net income is not same as gross income.
There are some subtle differences.
Of course, you will have to take the total revenue into consideration.
But there are some additional factors as well.
You have to make a sum of all the related business expense.
Also, take into account the cost of running the .business.
This is otherwise known as operating cost.
Now when you subtract these two heads from the total revenue, you get revenue before tax.
But hang on, this isn’t net income still.
A key deduction is still remaining.
Well, this is a complete list of all possible tax liabilities that a business has.
When all these numbers are subtracted, you get the total income.
It is almost like filtering the total revenue three times and removing impurities.
Not a speck of dust remains in the leftover amount.
It is unalloyed profit in its purest form.
So if gross income is more of an indicator of profitability, net income makes it specific.
It gradually removes all possible expense avenue and leaves behind simple profit.
But net income is as susceptible to manipulation as any other income calculating instrument.
This kind of manipulation can often be multipronged.
Whether you hide expenses or show aggressive income, this number will vary.
Therefore, you have to be careful while considering net income.
Be very careful about the various parameters.
This will undeniably reduce the scope of manipulation.
Key Difference Between Gross Income & Net Income
Therefore, this brings us to the most important part of this discussion.
How exactly is gross income and net income different?
It is very important to take note of the distinguishing elements.
That puts the entire deliberation in the right perspective.
In simple terms, gross income refers to income before tax payment, and net income is after tax.
But it is not just tax deductions that are factored in net income.
Any potential deduction will be removed from the final net income figure
For example, my net income is $50,000.
Now I qualify for $10,000 deductions on account of taxes.
So my net taxable income is minus this amount at $40,000.
Let’s say I fall in the 10% tax slab.
So my tax liability on $40,000 income is $4000.
Therefore my net income is $46,000.
So, net income becomes a very important parameter for calculating taxes.
For salaried people, the net income is minus a few other deductions as well.
Apart from the tax deductions, there is another important figure.
This is the retirement savings that you contribute towards every month.
So the net income is synonymous with the income in hand.
This is the final amount that you get every month minus all possible expenses and liabilities.
1. Measure of Profitability
One of the cardinal differences between gross income and net income is the purpose.
While net income is a more accurate reflection of profitability, gross income isn’t.
Gross income is a more realistic judge of the total income.
It is an account of all the sale proceeds of a business.
Through the entire financial year, the gross income is a record of every penny that has come in.
So in very simple terms, gross income is the amount your business brings in.
But this then does not account of the expenses.
The moment you factor in the expenses and liabilities, you get the net income.
So in many ways, a gross income is just a tentative indicator of profitability.
But if you want the exact measure, look for the net income numbers.
It gives you a pointed and focused perspective.
So, the scope of error is far limited in case of net income.
There are so many variables; manipulation is also fairly simple.
As a result, one has to be very careful about the exact methodology.
The core idea is to extract maximum value and leave bare minimum scope for any anomaly.
That will help you measure profitability accurately.
2. Planning the Cash Flow in Business
Understanding the difference between gross income and net income is imperative.
Apart from measuring profitability accurately, there are some other advantages as well.
Many times, a right perspective of these two helps you plan cash flow allocation properly.
For example, your gross income will never give you the right cash flow idea.
Only when you deduct the tax payments and expenses, you will get the actual figure in hand.
Then, you can calculate if you need more money to run your business.
If you feel that the actual cash in hand is less than what you need, you can look for loans.
On the other hand, if you see you can create a surplus, you can channelize that for other expenses.
So a gross income will help you determine future growth.
But net income helps you plan ways to address your present cash flow needs.
In many ways, you can then say that these two factors complement each other.
They help corporates and businesses create a focused business plan.
Even in terms of addressing your home budget, the difference is very important.
It is a crucial detail that helps you curtail expenses or add savings.
Advantages of Gross Income
When your gross income is at a satisfactory level, it helps in many ways.
It provides a definitive direction for your business.
1. Creates Healthy Financial Position
A healthy gross income is the first step towards healthy bottom-line.
Let’s face it; your net income is directly dependent on the gross revenue/income.
When you have a healthy gross income, it surely points towards consistent profitability.
It also helps in expanding the scope of business in a meaningful way.
For new businesses, a higher gross income can help a company break even faster.
So the earnings performance also improves in a significant manner.
It introduces better profitability prospects to the business over the longer term.
2. Impacts Cash Flow Positively
Perhaps the biggest impact is seen in the cash flow segment.
Higher gross income means a business is generating better revenues.
This directly impacts the cash flow.
The profit margin also has a huge role in determining the cash flow extent.
Now a good idea of the gross income levels, helps you calculate these with precision.
This means you have a much better grasp on the business financials.
It helps you to create a strong legacy of healthy accounting standards.
A markup in gross income also helps you derive better value from every dollar invested.
It also ensures a more meaningful initiative into mobilizing inventory.
More or less the gross income is often the most meaningful statement about business expansion.
Advantages of Net Income
Some of the advantages of net income include
1. Ease of Doing Business
It will help you in doing business effectively.
This is because it is one of the most important metrics to arrange the financing.
So when analysts see a satisfactory income level, it becomes easy to get financing.
Needless to mention, this improves business prospects.
2. Gauge Viability
Moreover the net income helps you identify sustainability prospects.
You will get a clear perspective of the overall viability of continuing a business.
You can plan future expansion on the basis of this number.
A consistent net income level is one of the best gauges of business viability.
3. Create a Strong Standing
A consistent net income also improves your business standing.
You are able to provide better salary and terms of employment.
You are also able to hire at will and expand as required.
Proper net income numbers also make your business more attractive.
Clients will be more biased towards companies that have consistent net income.
It enhances their standing in corporate circles.
Therefore, gross income helps you get a broader perspective.
But net income really gets down to specifics.
Whether it is your family budget or business plan, right financial planning is crucial.
If you know the gross income and a net income of your job, you can take a call on future.
You can compare it with another opportunity and then take a call.
Moreover, this difference helps you plan for the future in a comprehensive manner.
It helps you gauge the sustainability of the business also in a definitive manner.