To calculate net income, subtract every business expense from total revenue in a set order: start with revenue, take out the cost of goods sold, then operating expenses, then non-operating items, and finally income tax. What’s left is net income, the bottom line of the income statement and the clearest signal of whether the business actually made money during the period.
The Four-Step Formula
The calculation is one long subtraction, but it’s easier to run and easier to audit if you break it into four stages:
- Gross Profit = Total Revenue − Cost of Goods Sold
- Operating Income = Gross Profit − Operating Expenses
- Pre-Tax Income = Operating Income + Non-Operating Income − Non-Operating Expenses
- Net Income = Pre-Tax Income − Income Tax Expense
You can collapse the whole thing into a single line: Net Income = Revenue − COGS − Operating Expenses ± Non-Operating Items − Income Taxes. Running it in stages is better practice. If gross profit comes in wrong, you know to check production costs and pricing before you touch anything below it.
Pulling the Numbers You Need
Before any math, reconcile the trial balance and pull clean figures from the general ledger. A missed invoice at this stage quietly distorts every number that follows. Four categories drive the calculation.
Total revenue. All gross sales during the period, minus returns, allowances, and discounts. Under accrual accounting (ASC 606), revenue is recognized when the company satisfies its obligation to the customer, not when cash arrives. Product shipped in December counts as December revenue even if payment lands in February.
Cost of goods sold. Direct costs of producing what you sell: raw materials, direct labor, and manufacturing overhead. Service businesses may have very little here, but any direct cost of delivering the service belongs in this bucket.
Operating expenses. Everything it takes to run the business beyond production — rent, utilities, payroll, marketing, insurance, administrative salaries, professional fees, software. Payroll figures should include gross wages reported on W-2s plus the employer’s share of Social Security and Medicare taxes.1Internal Revenue Service. Depositing and Reporting Employment Taxes Depreciation on fixed assets and amortization of intangibles belong here too, even though no cash moves when you record them.
Non-operating items. Interest expense on loans, interest income on investments, and one-time gains or losses from selling assets. These sit in their own category because they don’t reflect how the core business is doing.
Step 1: Gross Profit
Subtract cost of goods sold from net sales. The result is gross profit, and dividing it by revenue gives the gross margin. A business with $2 million in net sales and $1.2 million in COGS shows $800,000 in gross profit and a 40% gross margin.
This is the first checkpoint. If margin has slipped against the prior period, the cause is almost always in production costs or pricing, not office overhead. Catching that here saves you from chasing the wrong problem two steps later.
Step 2: Operating Income
Subtract total operating expenses from gross profit. The result is operating income, also called EBIT (earnings before interest and taxes). It measures how profitable the core business is, before financing and tax choices enter the picture.
Operating expenses scatter across dozens of ledger accounts, so consistent categorization matters. Depreciation schedules should reflect each asset’s useful life and method — straight-line or accelerated — applied consistently. Switching methods mid-year without disclosure creates audit problems. Lenders and analysts lean on operating income because it filters out one-time noise; a business that only looks profitable because it sold a building tells a very different story from one whose day-to-day operations produce steady returns.
Step 3: Pre-Tax Income
Now add non-operating income and subtract non-operating expenses. Interest expense on business loans and lines of credit comes out. Interest earned on savings or short-term investments goes in. A gain on selling old equipment increases pre-tax income; a loss on the same sale reduces it.
For businesses carrying significant debt, watch the interest deduction limit. Federal law generally caps the business interest deduction at 30% of adjusted taxable income. Starting in 2026, adjusted taxable income once again allows adding back depreciation and amortization, which gives most businesses more headroom under the cap than they had from 2022 through 2024.2Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense Interest that exceeds the cap carries forward rather than disappearing.
Step 4: Net Income After Tax
Subtract income tax expense. For a C-corporation, the federal rate is a flat 21% of taxable income.3GovInfo. 26 USC 11 – Tax Imposed A company with $500,000 in pre-tax income owes $105,000 in federal corporate tax before credits or deductions. State corporate income tax stacks on top; the combined rate is what actually posts to the tax line.
Once total income tax expense comes off pre-tax income, you have net income. Tie the tax figure back to the tax provision in the general ledger. A mismatch usually points to an error either in the tax calculation or in an earlier step.
If the Business Is a Pass-Through
The 21% corporate rate applies only to C-corporations. Sole proprietorships, partnerships, LLCs, and S-corporations don’t pay income tax at the entity level. Net income passes through to owners’ personal returns and is taxed at individual rates.
That reshapes the math. If you run a sole proprietorship, your net profit lands on your personal return and is also subject to self-employment tax. The self-employment tax rate is 15.3% (12.4% Social Security plus 2.9% Medicare), applied to 92.35% of net earnings, and it kicks in once net self-employment income exceeds $400.4Internal Revenue Service. Topic No. 554, Self-Employment Tax For 2026, the Social Security portion applies to the first $184,500 in combined wages and self-employment earnings.5Social Security Administration. 2026 Cost-of-Living Adjustment (COLA) Fact Sheet Medicare has no cap.
Pass-through owners may also qualify for the Section 199A qualified business income deduction, which was made permanent by the One Big Beautiful Bill Act signed in July 2025.6Internal Revenue Service. One, Big, Beautiful Bill Provisions Eligible owners can deduct up to 20% of qualified business income, subject to income limits and phase-outs tied to filing status and business type.
When you calculate net income for a pass-through, then, you’re producing the taxable-income figure that flows to individual returns, not an entity-level tax bill. Self-employment tax and the QBI deduction both shape what the owner actually keeps.
When Net Income Is Negative
A negative result means the business lost money for the period. That loss has tax value going forward. Under federal law, a net operating loss carries forward indefinitely to offset future taxable income, and there’s no carryback for most businesses (farming operations get a two-year carryback).7Office of the Law Revision Counsel. 26 USC 172 – Net Operating Loss Deduction
The carryforward has a ceiling. In any future year, an NOL can offset only up to 80% of that year’s taxable income.7Office of the Law Revision Counsel. 26 USC 172 – Net Operating Loss Deduction If a company lost $200,000 in 2026 and earned $300,000 in 2027, the offset base is $240,000 (80% of $300,000). The $200,000 loss shelters $200,000 of that base, leaving $100,000 still taxable and no leftover NOL to carry forward. Document the loss properly so it’s available when the business turns profitable.
Net Income Is Not the Same as Cash Flow
A business can post strong net income and still run short of cash, or earn a modest profit while its bank balance climbs. Two things drive the gap.
First, non-cash expenses. Depreciation reduces net income every year of an asset’s useful life, but no cash leaves the business in those years; the cash went out when the asset was purchased. Stock-based compensation works the same way. These expenses are real for accounting, but they don’t touch the bank account.
Second, timing. Accrual accounting records $50,000 of December credit sales as December revenue even though the customer pays in January. Stockpiling inventory before a busy season sends cash out the door without any immediate expense hit, because the cost only shows up when the goods are sold.
The statement of cash flows reconciles the two figures, starting with net income and adjusting for non-cash items and changes in working capital. Rising net income paired with falling operating cash flow is a signal worth taking seriously — revenue on paper isn’t the same as money in the account.
Where Net Income Goes Next
Net income sits on the last line of the income statement, but it doesn’t stay there. It flows into the statement of retained earnings, where it’s added to accumulated profits and reduced by any dividends paid during the period. The updated retained earnings figure then carries to the balance sheet and lifts the equity section. Net income grows owners’ equity; a net loss shrinks it. If retained earnings doesn’t tie the two statements together, something is off in the books.
For companies with shareholders, net income also drives earnings per share. Basic EPS equals net income minus preferred dividends, divided by common shares outstanding. A company earning $10 million with $1 million in preferred dividends and 5 million common shares outstanding reports basic EPS of $1.80. Investors use EPS to compare profitability across companies of different sizes, so an error in the net income calculation carries straight through to valuation and shareholder expectations.