Why Understanding Net Operating Income and Net Income Is Critical

Starting your own business is an exciting time. You are finally fulfilling a dream and are now your own boss. While it is a thrilling prospect to own and operate your own business, there are some important things to keep in mind come tax time to avoid headaches or penalties.

I am often asked, said Mr. Riaz Mamdani, what kind of advice do you have in beginning a new company?

I strongly advise first time business owners to sit down with a financial planner so they can truly understand the basic elements of business financing. Learning key business terms is a major step in gaining this kind of understanding. I would particularly like to emphasize just how crucial it is that business owners and entrepreneurs know what Net Operating Income (or NOI) and Net Income are, and most importantly, the difference between these two terms.

In my mind, Net Operating Income and Net Income are two of the most important concepts associated with running a business. Net Operating Income refers to the income a business generates after operating expenses have been deducted, but before deducting income taxes and financing expenses. Operating expenses include rent, cost of materials, utilities, shipping and employee wages.

Net Income, on the other hand, refers to the amount of profit that remains after accounting for all expenditures, including expenditures like cost of materials, rent, utilities, shipping and wages, as well as taxes, interest paid, investment income, secondary operational income and payments made for one-time events such as lawsuits, are all considered expenditures.

Investopedia points out an interesting and I think worthwhile note: “Because both figures are subject to manipulation, such as hiding expenses to make a company appear more profitable, it is important to know how each type is calculated. When assessing a company’s viability as an investment, knowing how to calculate net income is infinitely preferable to simply reading the bottom line.”

A business’ Net Operating Income and Net Income figures are absolutely critical company data.  In the event a business performs extremely well and a business owner begins to pursue investors, these outside investors will scrutinize profit and loss statements and a business’ entire balance sheet.  Invalid or inaccurate data or inaccurate accounting will discourage outside investment.  That means that a business owner needs to understand how much profit their business is earning each year, discounting all forms of expenditures.

A business’ Net Operating Income and Net Income not only prove a company’s worth, these are figures that help gauge what a business needs to do to be more profitable and exactly how ambitious it can be financially.

An example of why understanding the difference between Net Operating Income and Net Income can sometimes be complicated. If a business owner uses a bank loan to help finance the business, the interest from these loans is considered an expense and reduces the company’s Net Income. Many first time business owners make the mistake of deducting such payments from the Net Operating Income instead of their business’ Net Income, which affects the bottom line and can cost a business profits.

It’s one more reason why in my opinion it is imperative that business owners have at least a basic understanding of business finance.