If you expect to have any hope of building wealth you need to have a firm grasp on basic financial concepts such as the difference between gross income and net income. If you don’t understand the concept of gross income vs net income you can never effectively manage your money. So let’s explain the difference between the two in simple terms both for individual consumers and for businesses.
In a nutshell, gross income is your total earnings before taxes and any other deductions are taken out. Net income is whatever is left after taxes and other expenses or deductions are subtracted out. Net income is always less than gross income.
For example, let’s say you get a job that pays $36,000 a year. You are paid twice a month, so each paycheck will have a Gross amount of $1,500. But of course that’s not what you’ll actually receive.
Your employer is required to withhold federal and state taxes, including Social Security. You may also have deductions for health benefits, life insurance, and retirement contributions. Whatever is left is your Net Income and it will be considerably less than $1,500.
The same idea holds true for businesses. The difference between gross income and net income can be enormous, and the numbers can tell two wildly different stories as to the health of the business.
Too many small businesses focus almost entirely on increasing revenues while barely giving their actual profits a second glance. But profits and cash flow are what keep a business going. What good are record revenues if you’re spending more money than you’re taking in?
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For example, let’s pretend you’re running an online store selling custom designed T-shirts. Your expenses would include the cost of creating, storing, and shipping the T-shirts to your customers. It would also include the cost of building and maintaining your website and many other business expenses including any advertising you do for your business.
You may be proud to tell anyone who asks that you’ve processed $50,000 worth of orders, but in reality that number is meaningless. How much did it cost you to fulfill those orders?
If it cost $15,000 to print, store, and ship them to your customers, another $5,000 to maintain your website, $3,000 in miscellaneous office expenses, and $15,000 in advertising expenses to bring in the business, your actual profit is only $2,000…a far less impressive number.
This is why you always have to take expenses into account when looking at either a business or personal income statement. A high gross income is certainly nice, but net income will give you a better overall look at your financial situation.