Essential Financial Statement Term for Stock Investors: 'Net Income'

What is Net Income?

Net income is one of the most important financial indicators for equity investors. It represents the final profit remaining after deducting expenses and taxes from the revenue a company earns over a certain period. Simply put, it's an indicator of how much money a company made in a year.

The reason it's important is that net income plays a crucial role in evaluating a company's business performance. A higher net income signifies that the company is operating efficiently and generating substantial profits. Conversely, a lower net income indicates that the company is facing difficulties or that expenses are exceeding revenue.

Considering net income when making investment decisions is crucial because companies with high net income are more likely to grow and develop in the future. However, this alone is not sufficient. It's essential to analyze it alongside other financial indicators and consider the company's outlook and competitiveness.

How to Calculate Net Income

Net income is calculated by subtracting the cost of goods sold, selling and administrative expenses, non-operating income and expenses, corporate tax, etc., from revenue. Below is a description of each item.

• Revenue: It represents the income a company earns from selling goods or services.
• Cost of Goods Sold: It refers to the expenses incurred in producing or purchasing goods or services. In manufacturing, it includes materials costs, labor costs, and manufacturing overhead.
• Selling and Administrative Expenses: It refers to the expenses incurred in selling goods or services and operating the company. It includes salaries, advertising expenses, rent, depreciation, etc.
• Non-operating Income: It refers to income generated from activities other than core business operations. It includes interest income, dividend income, and rental income.
• Non-operating Expenses: It refers to expenses incurred from activities other than core business operations. It includes interest expense, foreign exchange losses, and donations.
• Corporate Tax: It refers to the tax imposed on the profits a company earns.

For example, if Company A has revenue of 100 million won, cost of goods sold of 50 million won, selling and administrative expenses of 20 million won, non-operating income of 10 million won, non-operating expenses of 30 million won, and corporate tax of 10 million won, then the net income would be 100 million won - 50 million won - 20 million won + 10 million won - 30 million won - 10 million won = 20 million won.

In financial statements, net income is shown at the very bottom of the income statement, and the unit is expressed in won or millions of won.

Analysis of Factors Affecting Changes in Net Income

Net income is one of the representative indicators reflecting a company's business performance, and it's very important information for equity investors. Therefore, analyzing the factors that cause changes in net income can be said to be a process that must be gone through before investing in stocks.

The most basic cause is changes in revenueIf a company's revenue increases, it means that the company's products or services are gaining popularity in the market, which can be seen as a positive sign. On the other hand, if revenue decreases, it means that the company's products or services are losing their competitiveness in the market, which is a negative sign.

Next, we can mention changes in expensesGenerally, if expenses increase, net income decreases, and if expenses decrease, net income increases. However, in some cases, an increase in expenses can contribute to a company's growth. For example, an increase in research and development expenses can be seen as an investment in future growth.

In addition, exchange rate fluctuations, interest rate fluctuations, and political issuescan also affect net income, so caution is needed. Since these external factors are difficult to predict, before investing in stocks, you should consider not only the company's internal factors but also external factors.

Relationship with Other Financial Indicators

Net income is one of the core indicators of a company's business performance, so it is closely related to other financial indicators.

Among them, the most important is Return on Equity (ROE)ROE is the value obtained by dividing net income by equity, indicating how efficiently a company is utilizing its equity.

For example, for a company with net income of 10 billion won and equity of 100 billion won, the ROE is 10%. This means that the company earned a profit of 10 billion won by investing 100 billion won in equity, indicating that the company's business efficiency is high.

Debt-to-Equity Ratiois also closely related to net income. The debt-to-equity ratio is the value obtained by dividing a company's total liabilities by its equity, and it's an important indicator for evaluating a company's financial stability.

If a company has a high debt-to-equity ratio, it means that the company is experiencing difficulties in securing funds or incurring high financial costs such as interest expenses, which can lead to a decrease in net income. In the opposite case, it is possible to expect high net income.

Business Valuation using Net Income

Net income is one of the representative indicators of a company's business performance, and it's very important information for equity investors. It can be used to determine whether a company's stock price is appropriate. Some useful criteria to introduce for this include the following.

• Comparison with PER (Price-to-Earnings Ratio)PER is the value obtained by dividing the current stock price by earnings per share (EPS), indicating how many times the company's stock price is the earnings per share. If Company A's PER is 10x and Company B's PER is 5x, it means that Company B's stock price is relatively cheaper. In this case, if the net income of the two companies is similar, it may be more advantageous to invest in Company B.
• Comparison with PBR (Price-to-Book Ratio)PBR is the value obtained by dividing the market capitalization by net assets, and it is an indicator that can be used to determine whether a company's stock price is overvalued or undervalued relative to its net asset value. In other words, if the PBR is less than 1, it means that the stock price is so low that it does not even reach the book value of net assets (liquidation value), and if it is 0.5 or less, it is considered a good stock to actively consider buying.
• EV/EBITDA (Enterprise Value/Earnings Before Interest, Taxes, Depreciation, and Amortization) Ratiois also related. This is the value obtained by dividing a company's market value (EV) by pre-tax operating profit (EBITDA), indicating how much cash flow a company can generate using equity and debt. There may be differences depending on the country and company, so it's better to compare companies in the same industry. Generally, the lower this ratio, the more undervalued the company's market value is compared to the cash flow generated from operating activities, which can be interpreted as having a higher possibility of future stock price increases.

Limitations and Precautions of Net Income

As mentioned above, net income is one of the important indicators of a company's business performance, but it has some limitations and precautions.

First, depending on the accounting methodnet income can vary. For example, depending on the timing of expense recognition or the method of valuing inventory, net income can fluctuate. For this reason, even companies in the same industry can have different net income.

Second, there are limitations in predicting future profitabilityNet income is an indicator that reflects past performance, so it lacks the ability to predict external environmental changes such as future economic fluctuations or the emergence of competing companies. Therefore, making investment decisions based solely on net income can be risky.

Finally, it can be distorted by temporary factorsFor example, if a company undertakes a large-scale restructuring or sells assets, net income can temporarily increase, but this is unrelated to the company's actual business performance. Similarly, unexpected events such as exchange rate fluctuations or natural disasters can cause significant fluctuations in net income.

Therefore, equity investors should consider various financial indicators including net income in a comprehensive manner and analyze the company's business outlook and management strategies together to make investment decisions.

Conclusion

Today, we have learned in detail about net income, one of the basic financial terms that you must know when investing in stocks.