The Relationship Between Net Income & Owner's Equity

Net income leads to higher owner's equity and positive cash flow.

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Net income is the portion of a company's revenues that remains after it pays all expenses. Owner's equity is the difference between the company's assets and liabilities. It is the owner's share of the proceeds if you were to liquidate the company today. The relationship between net income and owner's equity is through retained earnings, which is a balance sheet account that accumulates net income.

What Is Net Income?

Net income is what remains after subtracting cost of goods sold, operating expenses and nonoperating expenses from revenues. Operating expenses include marketing, administration and rent. Nonoperating expenses include interest and taxes. Successful companies drive revenue growth, manage costs and grow net income. Execution problems and competitive pressures usually lead to declining revenues and profits.

What Is Retained Earnings?

The retained earnings account accumulates the portion of the company's net income that it does not distribute to shareholders as cash dividends. The accounting process involves transferring or closing the revenue and expense accounts at period end to a temporary income summary account. After subtracting dividends, the balance in this account is added to the starting retained earnings for the period. The ending retained earnings balance is higher if the net income is positive and lower if the net income is negative or a loss.

What Is Owner's Equity?

Owner's equity is the sum of the owner's contributions to his company and retained earnings, minus cash withdrawals. The corresponding term for corporations is "stockholders' equity," which is the sum of the proceeds from issuing stock and retained earnings.

Therefore, an owner's equity rises when a company generates a profit and retains part of it after paying dividends. Losses lead to lower owner's equity or even negative owner's equity. The owner could put in additional cash to continue operations, sell off surplus assets to raise cash or liquidate all assets and shut down the company.

Company Book Value

The owner's equity is usually a company's book value. The market value could be higher or lower than this book value. The market value is higher when investors are optimistic about a company's prospects for growing revenues and net income. The market value is lower when weak economic and industry fundamentals lead to expectations of flat or lower net income.

Calculation for Example Company

If a company's annual revenues are $5 million and its cost of goods sold is $1 million, the gross profit is $4 million. If operating and nonoperating expenses are $2 million, then the net income is $4 million minus $2 million, or $2 million. If the company pays dividends of $1 million to shareholders, the retained earnings are $2 million minus $1 million, or $1 million. Therefore, the owner's equity or stockholders' equity would increase by $1 million.