Net income (bottom line)

Net income at Hanil Widget Works

Fictional teaching case. Hanil Widget Works is an invented company used for this example.

Hanil Widget Works income statement (millions)

The arithmetic, one step at a time:

Gross profit = 100.00m − 69.50m
Gross profit = 30.50m

Operating income = 30.50m − 24.69m
Operating income = 5.81m

Pre-tax income = 5.81m − 1.15m
Pre-tax income = 4.66m

Net income = 4.66m − 1.81m
Net income = 2.85m

Net margin = 2.85m ÷ 100.00m
Net margin = 2.85%

That ratio alone does not explain whether the result comes from operating costs, interest, taxes or other items. The lines above it do.

How net income differs from operating income and EBITDA

Operating income is profit from running the business, before interest and taxes. At Hanil it is 5.81m.

EBITDA adds depreciation and amortization back to operating income. At Hanil:

EBITDA = 5.81m + 0.02m
EBITDA = 5.83m

Net income comes after interest and taxes. At Hanil it is 2.85m.

So the three measures answer different questions:

• EBITDA: what does the business earn before financing, taxes and noncash charges?
• Operating income: what does the business earn after depreciation, before financing and taxes?
• Net income: what is left for the current owners after everything?

Why private-equity buyers look past net income

A buyer does not buy the seller’s capital structure. Hanil’s 1.15m of interest reflects the debt Hanil carries today. A buyer that finances the deal differently will have a different interest bill.

Taxes depend on that interest, because interest is deducted before taxes. Change the debt and the tax line moves too.

That is why buyers usually value a business and size its debt from EBITDA or operating income, then rebuild net income under their own financing plan.

Net income still matters. It shows what the business actually produced for its owners under its real structure.

Reconcile profit to operating cash

Net income measures the period’s accounting result. The SEC’s financial-statement guide explains why operating cash flow adjusts that result for noncash charges and changes in operating assets and liabilities.

Hypothetical annual business, US$ thousands:

• Net income is 200, including depreciation of 30.
• Trade receivables increase by 100.
• Inventory increases by 40.
• Trade payables increase by 20.

Assume these are the only reconciliation items and all interest and taxes included in net income were paid within operating cash flow.

Start with net income = 200
Add back depreciation: 200 + 30 = 230
Subtract receivables increase: 230 − 100 = 130
Subtract inventory increase: 130 − 40 = 90
Add payables increase: 90 + 20 = 110
Operating cash flow = 110

Gap = 200 − 110
Gap = 90, or US$90,000

The US$90,000 difference is not another expense to subtract from net income. It describes cash timing and the noncash charge in this case.

To judge whether the gap is temporary, inspect receivable aging, inventory movements and supplier terms rather than treating profit as the available bank balance.

Related terms

• EBITDA
• Operating income
• Gross profit
• Net margin
• Operating cash flow
• Capital structure
• Income statement