Net income is literally the "bottom line" of a company -- it's the company's profit, as shown on the bottom line of its income statement. Profit, meanwhile, is one of the major components of shareholders' equity. Net income, therefore, gets factored into shareholders' equity. However, depending on how the company handles its profits, not all net income necessarily ends up in equity.
Shareholders' equity is the value of a company after accounting for all its debts and other financial obligations. In theory, it's what would be left over if the company were to liquidate its assets -- that is, sell off everything it owned -- and pay off every last debt. In corporate financial accounting, shareholders' equity has two primary components: paid-in capital and retained earnings. Paid-in capital is the money the company has raised by selling stock. Retained earnings are its accumulated profits.
The income statement, which every publicly held company is required to prepare and make available to investors, lists all sources of revenue -- sales, investment returns and so on -- and all expenses, such as wages, materials, interest costs and taxes. The statement's bottom line, all revenue minus all expenses, is net income, or profit. Of course, if expenses exceed revenue, the company has no net income; it has a net loss.
Retained earnings is the running total of the profits and losses a company has posted from the time it opened for business. Since net income is just another name for profit, it obviously has an effect on retained earnings -- but not just yet. First, the company's board of directors must decide whether it wants to distribute any profits to shareholders as a dividend. The "retained" in retained earnings refers to the fact that a company can pass some of its net income to shareholders, and retain -- hold on to -- the remainder. Some companies don't pay dividends. In those cases, net income goes directly into retained earnings, and thus into shareholders' equity. For companies that do pay dividends, the cost of the dividend comes out of net income. Whatever is left of net income after the dividend goes into retained earnings.
Where Stock Prices Fit In
Investors like companies that make a profit, so when a company posts a healthy net income, the stock price may rise. That's good for stockholders, because the shares they own are now worth more. But an increase in the share price has no effect on shareholders' equity. When a company sells a share of stock, it adds the sale price to its paid-in capital. Anything that happens to the price of that share from that point on doesn't appear on the company's books. That's why the total value of a company's outstanding stock, called its market capitalization or "market cap," often far exceeds its shareholders' equity.
- "Financial Accounting for MBAs"; Peter D. Easton, et al.; 2010
- Investopedia: Retained Earnings