Income Statement and Cash Flow
From revenue to net income, and from net income to free cash flow – how to read a company's earning power and why profit isn't the same as cash.
Key takeaways
- The income statement runs from revenue through costs to net income. Intermediate lines like EBITDA and EBIT help with comparisons.
- Margins show how much of each dollar of revenue is left. Stable, high margins suggest pricing power.
- Earnings per share spreads net income across all shares.
- Profit is an accounting number. What also matters is free cash flow – the cash actually left after all investment.
- If earnings run far above operating cash flow for years, look closely.
The balance sheet shows what a company owns. As a shareholder, though, what interests you most is what it earns – because profits ultimately fund dividends and price gains. Two statements cover that: the income statement and the cash flow statement. Reading them together tells you far more than earnings per share alone.
The income statement
The income statement (also called the profit and loss statement, or P&L) shows for a period – a quarter or a year – how revenue turns into profit, step by step.
The key lines:
| Line | What it shows |
|---|---|
| Revenue | All sales of products and services |
| Gross profit | Revenue minus direct production costs – what the product itself earns |
| EBITDA | Earnings before interest, taxes, depreciation and amortisation – a rough proxy for operating cash flow |
| EBIT (operating income) | Profit from the core business before interest and taxes |
| Net income | What’s left after interest and taxes, belonging to shareholders |
Margins: how much sticks?
Absolute numbers say little when comparing companies of different sizes. That’s why analysts use margins: the share of revenue left at each level.
- Gross margin: Example Corp 500 ÷ 1,000 = 50%. Software companies often reach 70–90%, grocers 20–30%.
- Operating (EBIT) margin: 200 ÷ 1,000 = 20%.
- Net margin: 150 ÷ 1,000 = 15%.
High and above all stable margins over many years suggest a company can raise prices without losing customers. Volatile or shrinking margins signal competitive pressure.
Earnings per share
Earnings per share (EPS) spreads net income across all shares outstanding. If Example Corp has 50 million shares, EPS is 150 ÷ 50 = $3. EPS is the basis of the price-to-earnings ratio. Note: when a company buys back shares, EPS rises even if total profit stays flat.
The cash flow statement: where’s the money?
Profit is an accounting concept. A company can book revenue as soon as it sends an invoice – even if the customer pays three months later. It can spread the cost of an investment over many years, though the cash left immediately. That’s why there’s a cash flow statement. It shows how much cash actually moved, in three blocks:
- Operating cash flow: cash from the business – customer payments minus payments to suppliers, staff and the tax authorities.
- Investing cash flow: spending on equipment, buildings and software (capex) and acquisitions, minus proceeds from sales.
- Financing cash flow: borrowing and repaying debt, dividends, buybacks, share issuance.
Free cash flow: the key number
Free cash flow is the cash left after all necessary investment. It can be used for dividends, buybacks, paying down debt or acquisitions – it’s what the owners could actually “take out”. Many experienced investors consider it more telling than net income.
Why earnings and cash flow diverge
In the short run, that’s normal. Growing companies invest more than they depreciate and build up inventory and receivables. It becomes a problem when a company reports high profits for many years but generates little or negative cash.
Other reasons to look closely:
- Stock-based compensation: Paying employees in stock costs no cash, but dilutes shareholders. Free cash flow then looks better than the economics justify.
- Capitalised costs: If development costs are capitalised on the balance sheet rather than expensed, today’s profit rises at the expense of future amortisation.
Summary
The income statement shows how revenue becomes profit; margins make companies comparable. The cash flow statement shows how much of it arrives as cash. Free cash flow – operating cash flow minus capex – is for many professionals the most honest number, because it’s harder to dress up than earnings. With this knowledge, the next lesson asks whether a stock price fits the numbers.
Time to practise
12 short exercises on this lesson – mistakes come back at the end. Then the lesson is complete and joins your review queue.
Test your knowledge
0/301A company has $1,000m of revenue and $150m of operating income (EBIT). What is its operating margin?
02How is free cash flow calculated, in simple terms?
03A company reports rising profits year after year, but its operating cash flow is persistently negative. What could be going on?