Nothing strikes fear in the heart of small business owners more than looking at your income for the quarter or year and realizing that it’s lower than you projected—or worse, lower than the quarter or year before.
You probably immediately jump to thoughts of your business going under, of having to tell everyone you failed, applying to “normal” jobs again with your head hung low.
But before you jump to these conclusions, I have a question: Are you looking at your net income or your operating income? Do you even know the difference?
Most people in this moment of panic are probably looking at their net income, which might not give you the whole picture. In fact, looking at your operating income could quell your concerns and help you see a more hopeful financial future for your business.
What is Operating Income?
Operating income tells you your business’ income based solely on normal, day-to-day expenses involved with running your business. It’s calculated by taking your gross profit and only subtracting operating expenses: things like rent, wages, marketing, insurance, software subscriptions, etc. These are the expenses you can expect to have regularly—every month or every quarter—and that may decrease if you make an effort to cut back in some areas, but are unlikely to go away entirely as long as you’re running your business.
What is Net Income?
Net income tells you your business’ actual income for the given time period. This includes all the same expenses as operating income but also includes any non-operating expenses. It’s easiest to think of these as surprise expenses—things you wouldn’t regularly be spending money on to run your business. Think a major computer or equipment purchase that only happens once every 4-5 years, a consultant you hire for a month to help you clean up some operational processes, a lawsuit that you have to hire a lawyer to help you deal with, or expenses from accrued interest on debt. It’s nice to separate these expenses out because they’re unlikely to happen again for a while.
Operating Income vs. Net Income: Which Should You Pay Attention To?
So, which is the number you should be looking at to determine how you’re doing financially? The answer is both, but they tell you different things—and looking at operating income may give you a more realistic picture if you’re looking at unusually low income for a quarter.
Let’s look at an example. This is the income statement over two quarters for Jeri, a freelance graphic designer. Pay special attention to the operating income and net income—for more on how to read this entire income statement, head over here.
| Q1 Income Statement | Q2 Income Statement | ||
|---|---|---|---|
| Revenue | Revenue | ||
| Sales | $20,000 | Sales | $25,000 |
| Cost of Goods Sold | ($5,000) | Cost of Goods Sold | ($7,000) |
| Gross Profit | $15,000 | Gross Profit | $18,000 |
| Operating Expenses | Operating Expenses | ||
| Rent | $1,500 | Rent | $1,000 |
| Insurance | $1,200 | Insurance | $1,200 |
| Contractors | $3,000 | Contractors | $3,000 |
| Marketing | $600 | Marketing | $400 |
| Supplies & Software | $300 | Supplies & Software | $300 |
| Total Operating Expenses | $6,600 | Total Operating Expenses | $5,900 |
| Operating Income | $8,400 | Operating Income | $12,100 |
| Non-Operating Expenses | Non-Operating Expenses | ||
| None | $0 | Legal Fees | $10,000 |
| Total Non-Operating Expenses | $0 | Total Non-Operating Expenses | $10,000 |
| Net Income | $8,400 | Net Income | $2,100 |
If Jeri were just calculating her net income, she would probably panic about the future of her business—her total income tanked for Q2, down by over 50%. While that doesn’t look great, by separating it out operating income and net income, you get a clearer picture.
When Jeri looks at her operating income, she can see that—day-to-day—her business is doing fine, great even. Her profit was higher this quarter and she managed to cut down on some of her operating expenses, finding a cheaper co-working space and making her marketing spend more efficient. Based on her operating income, her business had a healthy 44% growth.
What caused the problem in her net income was a non-operating expense—she was sued by one of her clients and lawyers aren’t cheap. This is something that hopefully won’t happen again (at least not for a very long time), so it doesn’t help Jeri to include it in the calculation as she considers the long-term growth of her business. Still, it’s important to pay attention to net income, too. If you regularly have non-operating expenses that are bringing your income down, it could be worth digging into what’s going on there and looking for ways to avoid those moving forward.
Abridged by Amy
- Operating income tells you your business income based on the regular expenses associated with operating our business.
- Net income also accounts for any non-operating expenses, or unusual expenses that you don’t anticipate coming up again for a while.
- Understanding both operating and net income is important. Operating income can give you a clearer picture of the trajectory of your business growth assuming normal operations, while net income can show you how surprise expenses are affecting your business.
