Filing federal income taxes can be overwhelming without having proper direction on how to calculate your earnings properly. Net income and gross income are two terms that can get confused easily. This article will help give you a quick rundown on how to determine your net income and gross income as a business or an individual.
Gross Income (Gross Profit)
Businesses: Gross income is defined as the number a business makes (business income) before subtracting any taxes or business expenses. A business’s gross income as a calculation can be seen as the gross revenue minus the COGS (cost of goods sold).
Another word for gross income is a business’s gross margin or gross profit. These numbers are important to examine when calculating total sales by looking at how much it costs your company to make or manufacture a product. These two numbers should demonstrate a relationship where one is smaller (COGS) and the other is larger (revenue). For example, if your business is selling rocking chairs, it shouldn’t cost you more to produce your chair than you are making in revenue. Gross income in this situation would be the revenue – the costs of producing the rocking chair.
Adjusted gross income (AGI) is determined by state and federal income tax laws, to set taxable income and tax liability. Social security payments, retirement plan contributions, health insurance premiums, healthcare, savings account payments, medical expenses, medicare tax, and more are some examples of taxable income.
Individuals: For individuals not owning a business gross income, also known as gross pay, is the number that you see on your paycheck before taxes are taken out. For example, if you get a weekly paycheck of $1,500 after your taxes were taken out, that is your gross income. It is much easier for individuals to calculate their profit margins, as there are fewer numbers used for tax deductions.
Net Income (Net Profit)
Businesses: For businesses, net income is the number represented by the formula revenue – (cost of goods + business expenses + depreciation + taxes). In short, this formula can also be seen as total revenue – total expenses = net income. Determining your business’s net earnings will help you get an understanding of your profits. This calculation can also help a business determine how profitable it really is after seeing how much it costs them in additional expenses. In essence, net income subtracts expenses in addition to the cost of goods such as travel expenses, labor costs, selling expenses, operating expenses, marketing, and advertising, taxes, office costs, and more. Unlike a business operating profit, which does not take taxes and certain one-off items into account, net income will subtract all additional incurred expenses.
Individuals: Similar to gross pay, it is also easier for wage earners to calculate their net income. Net income is the formula that can be used to determine one’s take-home pay after subtracting benefit payments, healthcare, health insurance premiums, medicare tax, retirement plan contributions, and any other pre-tax benefits. COVID-19 unemployment benefits would be another example of taxable income that would need to be reported to the IRS on tax returns. This number can help individuals examine their personal finances and the “profitability” of their job.
The Bottom Line
As an individual or a business owner, being able to differentiate between your gross income and net income is crucial for personal finance, and having a successful business. Keeping track of financial statements and income statements will make it easier to calculate taxes, deductions, and profit margins for your business.
For personal finance, gross income and net income are closely tied together. However, business calculations can become more complex when dealing with multiple different products, inventory, equipment, additional expenses, and more. In order to maximize success and keep your business cash flow and personal finances running smoothly, it is important to keep track of all your earnings and expenses.
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