How Annual Net Income is Calculated and What it Means for Investors

By Markets Fool.com

"Annual net income" (or sometimes just "net income") is a phrase that investors throw around alot. And supposedly we all know what it means: It's the "bottom line," the income that is left after everything else is deducted.

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But what exactly is "everything else" in this context? What does a company's net income number really tell us? And when might it be more useful to look at another income number to better understand how much money a company is making?

What "annual net income" includes -- and what it doesn't
"Net income" turns out to have a pretty strict definition. To calculate it, we take the company's revenue, or all the money it made from sales, and adjust it up or down (nearly always down) for the cost of doing business, depreciation on the company's assets, interest payments, taxes, and certain kinds of other expenses.

You don't have to calculate it yourself. You can find it in the company's standard quarterly statements -- specifically, on the income statement. It's also typically the number that media reports will focus on, at least for U.S. companies. Either way, it's not very hard to find.

"Annual net income" is simply the net income for a given year, four quarters in a row.

It's referred to sometimes as the company's "bottom line", because net income is at the bottom of the standardized income statement. (Revenue is sometimes referred to as "the top-line number" for the same reason -- it's at the top.)

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But even though we think of "bottom line" as being the last word, like any accounting measure it's susceptible to manipulation. Companies can be tricky about how they recognize or "book" revenue, for instance by finding reasons to record a sale as a done deal before they actually have the money in-hand. And expenses can be hidden in other figures to lessen their impact on net income.

But even when companies aren't engaging in accounting shenanigans, net income can sometimes be a misleading number when evaluating a company as an investment.

When net income doesn't accurately reflect the health of the business
For example, take a company that is familiar to just about everyone, General Motors (NYSE: GM).

GM's net income for 2014 was $2.8 billion. But Germany's Volkswagen Group (NASDAQOTH: VLKAY) had net income of $11.8 billion. VW sold more cars and trucks around the world than GM in 2014, but not by much -- 10.14 million to 9.92 million.

"Wow," we might say, looking only at those numbers. "GM has some serious problems. Steer clear of that stock."

But that number only gives us a small part of the story. If we instead take GM's earnings before interest and taxes, which was $6.5 billion, and we compare it to VW's ($16.1 billion), it looks a little better. Add back in the $2.5 billion in expenses that GM incurred for its giant wave of recalls (expenses that aren't a direct reflection of the state of GM's ongoing business, and that we don't expect to recur), and we get GM up to $9 billion. Still not close to VW, but at least not embarrassing.

And in truth, that's a more accurate picture. Six years removed from bankruptcy, GM is solidly profitable and in good financial shape -- but it still has a long way to go to catch up to the profitability of its two closest global peers, VW and Toyota (NYSE: TM) (which made even more money last year).

Now, as investors, we might dig a little deeper, find out that CEO Mary Barra has a plan to close that profit gap by early next decade (she does), evaluate the plan (it's a good one, but it's not a slam-dunk), look at GM's current stock price and how that relates to its 2014 income (net and otherwise), and make our investing decisions from there.

But the real lesson here is that net income didn't tell us anything like the whole story.

Watch out for taxes, which can affect different companies in very different ways
Taxes are one big factor that can throw off apples-to-apples annual net income comparisons. Different companies face different tax circumstances -- and VW, as a German company, deals with a different set of corporate tax rules than does GM in the U.S.

Generally, when we're comparing companies that are headquartered in different countries, we're better off comparing "operating income" -- which adjusts for expenses like wages, the cost of goods sold, and depreciation, but not for taxes or interest. (Dividing operating income by revenue gives us a company's operating margin, a good measure of its profitability.) But even then, sometimes an "earnings before interest and taxes" number that excludes one-time expenses gives us an even better picture of the health of the business.

It all comes down to getting to know a company before you invest. No one number is going to give you a complete picture all by itself. But once you start to understand the context -- the underlying business -- a company's annual net income number can help you see the bigger picture.

The article How Annual Net Income is Calculated and What it Means for Investors originally appeared on Fool.com.

John Rosevear owns shares of General Motors. The Motley Fool recommends General Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.