Part of being a successful business owner includes knowing how to measure the financial performance of your business. Without this critical skill, you wouldn’t be able to take corrective action when needed. You also wouldn’t have an accurate picture of how much spending power you have.
Today we will discuss net income, which measures how much income you’ve generated after accounting for all costs. Keep reading to learn how to calculate net income and use the specific formula used by real estate investors.
What Is Net Income?
Net income is used by investors, entrepreneurs, and businesses to understand how much revenue exceeds expenses. Individuals can also use net income to analyze how much income they have left over after paying expenses.
Net income, or net earnings, is an important measure of profitability. The number is calculated using an easy formula, which can be used for any time period.
Net Income Formula
Put simply, net income represents profits left over after paying all expenses. There are a few different iterations of the formula. Each version is derived from the same concept but is adapted to a specific scenario.
For example here is a version that can be used to track your personal income and expenses:
Net Income = Gross Income – Expenses
The same formula takes on a slight variation if you want to calculate net income for your business:
Net Income = Total Revenues – Total Expenses
Finally, the formula can be expanded upon to accommodate different accounting methods:
Net Income = Total Revenue – Cost of Goods Sold – Total Expenses
Note that your net income can be a positive or negative number. If your business revenue exceeds expenses, your net income will be positive. Obtaining a high positive net income is the goal. This can be done by increasing revenue, minimizing expenses, or both.
How To Calculate Net Income For A Business
The net income formula can be used to get a financial snapshot of any given period, such as monthly, quarterly, or annually.
Let’s use an example to demonstrate how to calculate net income for a business. Real Estate Investor, LLC generated an annual revenue of $200,000 from January 1 to December 31, 2021. During this period, they paid $42,000 in taxes. The LLC also spent $60,000 in operating expenses, including property repairs, marketing, and general administration.
Using the simple formula for business, the net income calculation would like this:
Net Income = Total Revenues – Total Expenses
Net Income = $200,000 – ($42,000 + $60,000)
Net Income = $200,000 – $102,000
Net Income = $98,000
In this example, Real Estate Investor LLC used the net income formula to find out that the business generated $98,000 in net income after all expenses.
How To Calculate Individual Net Income
Another version of the formula can be used to calculate individual net income. Jonathan is the owner of Real Estate Investor LLC. He pays himself a monthly salary of $5,500.
However, that’s not the final amount that is deposited into his paycheck. We must subtract his expenses to find out his net income. He pays $570 in federal income tax, $272 in state and local tax, $325 in social security, $76 in Medicare, and $250 toward the employee-paid portion of his health insurance. These expenses amount to $1,493 in total.
Using the individual net income calculator looks like this:
Net Income = $5,500 – $1,493
Net Income = $4,007
In this example, Jonathan’s monthly net income is $4,007 after all payroll deductions have been made.
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Why Is Net Income Important?
Net income is important because it tells us how much we can spend on a discretionary basis. As an individual, this might include our living expenses and anything we want to spend on food, shopping, travel, and entertainment.
A business will look at net income to analyze its own financial health and what funds might be available to fund capital projects.
Both individuals and businesses can also utilize net income to scrutinize how many expenses they have relative to income. Data can be used to create financial projections and take corrective action if needed.
Net Income Vs. Gross Income
So far, we’ve discussed how net income is an important calculation used by individuals and businesses. How is net income different from gross income?
Gross income is the total income, or revenue if you’re a business, you’ve made in any given period of time. For an individual, this could be the total monthly or annual salary. For a business, this could be the total amount of revenue made from paying customers or clients. A real estate investor might tally up their total rental income in a given period.
However, your gross income doesn’t describe how much money you can actually spend. Every individual or business has expenses and liabilities that are paid using a portion of their gross income.
Your net income is the money you have left over after paying your expenses, including any taxes and debt.
In short, gross income is the number to look at if you want to know how much money you’re making. Net income is the number to look at if you want to know how much money you have to spend or invest.
How To Calculate Net Income For Real Estate Investments
Different businesses will calculate net income differently, based on their respective industries and accounting methods used. Earlier, we mentioned an example where a business subtracts the cost of goods sold (COGS) and other expenses from total revenue to arrive at their net income. However, this formula wouldn’t apply to any type of business that does not sell a product. A different type of business might use a different expense category other than COGS.
With that being said, let’s dial down how a real estate investor would calculate their net income.
Net Operating Income Formula
Without delay, here is the formula for calculating net operating income for real estate investments:
Net Operating Income: Rental Income + Other Income – Vacancy Losses – Total Operating Expenses
The above formula is widely used by real estate investors who own income-producing properties. It can be used to measure an existing property’s financial performance or make financial projections for a property you’re interested in acquiring. You can also use the formula to measure your rental properties’ financial performance.
Before you can make the net operating income calculation, you must collect financial data so that you can come up with the variables included in the formula. We explain each of the variables next.
Potential Rental Income
The first number you’ll need to calculate is the rental income of the property in question. For an existing property, this is a matter of simply adding up all of the rental income you’ve collected in a given period.
For potential rental income, combine the total rent of the property within a given period. Assume that the property is fully occupied with no vacancies, which we will account for next. For example, if you are leasing a two-unit property at $2,500 per month, then your potential rental income would be $60,000 in one year. ($2,500 rental rate x 2 units x 12 months.)
In a perfect world, your rental property would have zero vacancies. However, this typically does not happen. It could take several weeks to months to fill a unit between tenants in a slow market. Even in a hot rental market, you still need to account for the number of days it could take to turn over a unit between tenants for cleaning and maintenance. This loss of rental income will eat into your final net income. Even if you did not have any vacancies in a given period, it’s still a good idea to set aside a certain percentage of your income to cover the cost of future vacancies.
To calculate a vacancy loss, simply take the rental amount of a unit and multiply it for the number of months that it sat vacant. For example, let’s say one of your duplex units took 2 months to fill. That’s a vacancy loss of $5,000 that you would subtract from your gross rental income. ($2,500 rental rate x 2 months = $5,000.)
Other Sources Of Income
Some real estate investors find creative ways to bring in additional revenue without raising their rental rates. For example, you could charge a monthly fee for designated parking spaces, or provide coin-operated laundry on-site. Larger complexes may even offer a gym or communal event space that can be used at extra cost.
These are optional features that residents can reasonably live without if they don’t want extra expenditures. As a landlord, you get to bring in more revenue and provide premium services to tenants without unnecessarily hiking up their rent. It’s a win-win!
Total Operating Expenses
Running a rental property can be expensive. At the end of the day, as a real estate investor, you want to make sure that your expenses don’t exceed your income. To find out your total operating expenses, simply add up your various expenses associated with owning, renting, and running your investment property.
Examples include property taxes, insurance, management fees, maintenance, and repairs. Don’t forget miscellaneous expenses, including marketing, legal, and office supplies.
Knowing how to calculate net income is a requirement for any type of business owner. It’s an important measure of your company’s financial performance. If your expenses are consistently exceeding your income, you need to know this information to take corrective action. Your net income also informs you on whether you’re financially ready to take on your next capital project.
The net income formula can be adapted to work for your specific industry and business. Real estate investors use a version called net operating income, which accounts for rental property income, operating expenses, and vacancy losses. If you own rental property, be sure to memorize this formula so that you can run your financial analysis regularly and measure the health of your business.
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