Income statement

The income statement covers a period, a quarter or a year, and answers one question: over that period, did the business make a profit? It starts with revenue and works down through layers of cost to net income, each subtotal answering a slightly different question about where the money went.

Revenue less cost of goods sold gives gross profit, which measures the profitability of the product itself. Subtract operating expenses and you get operating profit, or EBIT, which measures the profitability of running the business. Subtract interest and you have moved from the business to the shareholders, because interest is what the lenders take. Subtract tax and you reach net income, which is what belongs to the equity holders.

That interest line is the single most important structural feature of the statement, and it is the reason enterprise value pairs with EBITDA while equity value pairs with net income. Everything above interest is available to all capital providers. Everything below it has already had the lenders paid.

The statement is prepared on an accrual basis, so it contains genuine costs that involve no cash at all, depreciation and amortisation being the obvious ones. That is exactly why net income is a poor proxy for cash generated, and why the cash flow statement starts from net income and immediately begins adding things back.