Essentially, net income tells an investor if a company is profitable. When a company is able to retain more of their revenue, it means they will be more likely to pass along these profits to shareholders in the form of dividends or reinvest the money back into their business without having to take on debt. Both of these are positive signs that their stock may draw the interest of other investors and be set to go higher. It’s important, however, for investors to review net income in a historical context. Sometimes a positive net income number may be sharply lower than the number posted the previous quarter or at the previous quarter in the same period last year. This does not by itself mean the company is a risk, but it does mean that investors should exercise due diligence to determine as best they can the reason for the change in net income.
Net income is also important because it is the basis upon which companies make other calculations such as earnings per share (EPS), their net profit margin, and as the starting point for their cash flow statement.
For earnings per share, net income is used as part of the following calculation:
EPS = net income – preferred dividends/weighted average common shares
Notice that preferred dividends are deducted. If a company does not issue a dividend on their preferred stock, the equation would be simply:
EPS = net income/weighted average common shares
Net profit margin is used to compare a company’s level of profitability to previous quarters or with other companies of similar size within their sector. In its simplest form, it is a ratio of a company’s net income to its revenue. The calculation is:
Net Profit Margin = Net Income/Revenue
When used with a cash flow statement, a company’s net income is brought over from their income statement and used as the first line item on their cash flow statement. Cash flow differs from net income because net income accounts for non-cash expenses such as depreciation, amortization and stock-based compensation.