The income statement and the cash flow statement
The answer
The income statement says what the company earned over a year, using estimates. The cash flow statement says what money actually moved over the same year, using bank records.
Read them together, for 3 years, and the difference between them tells you more than either one alone.
Why this costs you money
Every headline you have read about a company's results quoted 2 numbers: revenue and profit. Both come from the income statement. Neither is a measurement of money.
A company sells ₹100 crore of goods on credit in March. Revenue rises ₹100 crore. Profit rises by whatever is left after costs. No money has arrived. If the customer never pays, the correction may not appear for 2 years.
A company spends ₹300 crore and decides it is an asset rather than an expense. The cash left. The income statement barely notices, because the ₹300 crore now sits on the balance sheet and will be charged against profit slowly over 10 years. Profit stays high. Cash is gone.
A company changes the estimated life of its machines from 8 years to 14 years. Annual depreciation falls. Profit rises. Nothing changed in the factory.
All 3 are legal. Every one widens the gap between reported profit and cash from operations.
Profit is an opinion. Cash is a fact. The cash flow statement exists because the accounting profession knows the income statement can be steered. It starts at profit and shows you, line by line, everything that has to be undone to get back to money. It is the most useful half page in corporate reporting and it is the page most retail investors have never opened.
How it works
The income statement, layer by layer
Each line subtracts something and gives a subtotal with a name. Learn the 4 subtotals and you can read any income statement in either country.
Revenue. What customers were billed for goods and services delivered. Under Ind AS 115 and its American twin ASC 606, revenue is recognised when control of the goods or services passes to the customer, not when the cash arrives. That one rule is why revenue and cash differ.
Gross profit = revenue minus the direct cost of what was sold. Gross margin is gross profit divided by revenue. A stable gross margin suggests pricing power. A falling one suggests the company is discounting, or its input costs are rising and it cannot pass them on.
Operating profit = gross profit minus the cost of running the business: salaries, rent, marketing, administration, depreciation and amortisation. This is profit before financing and before tax. In India it is often called EBIT, earnings before interest and tax.
Profit before tax = operating profit minus interest cost, plus other income. Other income deserves attention. It includes interest earned on deposits, rent and gains on selling assets. A company whose profit before tax is growing because of other income is not growing its business.
Profit after tax = profit before tax minus tax. This is what flows into retained earnings on the balance sheet.
Earnings per share, or EPS = profit attributable to equity shareholders ÷ weighted average number of shares. Basic EPS uses shares outstanding. Diluted EPS assumes every option and convertible instrument turns into shares. Always read diluted EPS. It is the number that reflects what your slice will actually be.
Exceptional items
An exceptional item is a large, unusual charge or gain disclosed separately so it does not distort the underlying picture: restructuring costs, an impairment, a legal settlement, a gain on selling a division.
The concept is legitimate. The pattern is not always. A company reporting an exceptional charge every year for 5 years does not have exceptional items. It has ordinary costs shown below a subtotal, so that commentators can quote profit "before exceptional items" instead.
Count them. It is a 2-minute check and it is remarkably informative.
The cash flow statement, 3 sections
Cash from operating activities. The business itself. Almost every company uses the indirect method, which starts at profit before tax and then adjusts:
- Add back depreciation and amortisation, because they reduced profit but moved no money.
- Add back or subtract non-cash items such as impairments and provisions.
- Adjust for changes in working capital: an increase in receivables or inventory reduces cash, an increase in payables increases it.
- Subtract tax actually paid.
That list of adjustments is the difference between the opinion and the fact, itemised. Read it slowly once and you will understand the company's year better than from any other page.
Cash from investing activities. Money spent on property, plant and equipment, called capital expenditure or capex, and on acquisitions. Money received from selling assets or from investments maturing.
Cash from financing activities. Money raised from lenders and shareholders, money repaid, interest paid, dividends paid, and buybacks.
The pattern to look for
| Section | A healthy mature company | A company depending on lenders |
|---|---|---|
| Operating | Large and positive | Small, erratic or negative |
| Investing | Negative — it is building | Negative, or positive from asset sales |
| Financing | Negative — repaying and paying dividends | Large and positive |
The second column is not automatically a problem. A young company growing fast looks exactly like that, correctly. The question is how long it has looked like that, and whether it is improving.
Free cash flow
Cash from operating activities − capital expenditure = free cash flow
This is the money left after keeping the business running and investing in it. It is what can pay dividends, repay debt, or fund acquisitions without borrowing. It is not an official line in either country's statements. You calculate it from 2 numbers that are.
What it tells you, and what it does not
Together they tell you whether the profit is converting into money, how the company is funding itself, and how much it must spend to stand still.
They do not tell you the numbers are honest. Revenue itself can be fabricated, and if the money is cycled through related parties then operating cash can be fabricated with it. The cash flow statement is harder to falsify, not impossible.
Operating cash flow can be improved temporarily. Delaying supplier payments, collecting aggressively at year end, or selling receivables to a bank all raise operating cash without any improvement in the business. Selling receivables, called factoring, is the one to watch: it can make a deteriorating collection cycle look stable.
And the classification is a choice in places. Under Ind AS, interest paid can be shown in operating or financing activities. That choice changes reported operating cash flow without changing anything real.
The decision rule
Compare cumulative profit after tax against cumulative cash from operations over 3 to 5 years. Over that length of time, the 2 should be close, and operating cash should usually be larger.
If cumulative profit is much larger than cumulative operating cash, the profit is sitting in receivables, inventory or capitalised costs rather than in money — unless the company is genuinely growing fast, in which case the gap should narrow when growth slows. If growth slows and the gap does not narrow, the gap was never about growth.
Try this now
Twenty minutes, on 1 holding. Two exercises, and the first one is the most valuable check in this entire cluster.
Exercise 1: the conversion check.
- Open the last 3 annual reports for 1 holding. Each report shows 2 years, so 2 reports covers 4 years if you prefer.
- For each of the 3 years, write down 2 numbers: profit after tax from the income statement, and net cash from operating activities from the cash flow statement.
- Add up the 3 years of profit. Add up the 3 years of operating cash. You now have 2 totals.
- Divide cumulative operating cash by cumulative profit. Call it the conversion ratio.
- Now subtract capital expenditure, from the investing section, from each year's operating cash to get free cash flow for each year.
What you should see. For most established companies the conversion ratio is above 1, often between 1.1 and 1.5, because depreciation is added back. Between 0.8 and 1 is usually fine and reflects a growing working capital cycle.
If it is below 0.6 across 3 years, you have found something that needs an explanation, in a company you own. Go back to the operating section and read the adjustment lines. In almost every case the answer is visible: a large negative "change in trade receivables" or "change in inventories", repeated every year. That tells you where the profit went.
Exercise 2: the exceptional item count.
- Open the same annual report as a searchable document and search for exceptional. In an American 10-K, search for restructuring, impairment and non-recurring.
- Count how many of the last 3 years contain one.
- For the latest year, find the amount, and calculate profit before and after it.
What you should see. Most companies have none in most years. If you find an exceptional item in all 3 years, the word is doing work it should not be doing. Add them all back and look at what the profit trend becomes. That is the trend that actually happened.
Three real cases
1. WorldCom, 25 June 2002 (United States) — operating costs recorded as assets WorldCom's internal audit team, led by vice president Cynthia Cooper with audit manager Glyn Smith and accountant Eugene Morse, examined capital expenditure in 2002 and found entries moving line costs — the fees WorldCom paid other carriers to use their networks — out of expenses and onto the balance sheet as capital spending. They identified 49 entries totalling about $3.8 billion across 2001 and the first quarter of 2002. Booking a cost as an asset raises reported profit immediately and leaves cash unchanged. The chief financial officer was terminated on 25 June 2002 and the disclosure followed. WorldCom filed for bankruptcy on 21 July 2002, and assets were eventually found to have been overstated by more than $11 billion. The money had genuinely left the company. Only the income statement pretended otherwise.
2. Enron Corporation, 2000 and 2001 (United States) — profit recognised years before any cash Enron applied mark-to-market accounting to long-term energy contracts. On signing a 20-year contract it recorded the estimated present value of expected future profits as income in the year of signing. No money changed hands. When estimates later proved wrong, hundreds of special purpose entities were used to hold the results. On 16 October 2001 Enron restated results, cutting reported earnings by $613 million and reducing equity by $1.2 billion. It filed for bankruptcy on 2 December 2001. Reported profit had risen for years while cash from operations had not kept pace.
3. Luckin Coffee, 2 April 2020 (China, listed in the United States) — the top line itself Muddy Waters published a report on 31 January 2020 alleging inflated sales, based partly on counting customers in stores. On 2 April 2020 Luckin announced that an internal investigation had found its chief operating officer and others had fabricated approximately RMB 2.2 billion of 2019 sales, about $310 million. The shares fell around 75% in a day, trading was suspended on 29 June 2020 as Nasdaq moved to delist, and the SEC settlement was $180 million on 16 December 2020. This is the honest limit on everything in this article: when the revenue line is invented and cash is cycled to match it, the conversion check alone will not catch it. Independent evidence about the business was what caught it.
The question that resolves it
A novice reads results and asks: did profit grow?
An expert asks: did profit grow, did operating cash grow with it, and if not, which line in the operating section explains the difference?
That third part is what makes the question usable rather than sceptical. The cash flow statement itemises the answer. It is either receivables, inventory, payables, tax, or a non-cash item, and there are only about 8 candidates. You can find the culprit in 2 minutes on a page the company printed itself.
What would make this wrong
If operating cash were always the truer number, then every company with weak operating cash would be a poor investment. Many of the best businesses in both countries had years of negative operating cash while they grew.
Three honest limits.
Growth consumes cash, and that is correct behaviour. A company doubling its store count must fund inventory and receivables ahead of the sales. Operating cash can lag profit for years legitimately. The test is directional: does the gap narrow as growth slows?
Financial companies do not fit this framework. For a bank or a non-bank lender, making loans is an operating activity, so a growing lender shows deeply negative operating cash flow by construction. The conversion ratio produces a frightening number there and a meaningless one. Use net interest margin, asset quality and capital adequacy instead.
Cash can be manufactured too. Factoring receivables, delaying supplier payments and reverse factoring all raise reported operating cash without improving anything. Some must be disclosed and some are visible only as an unexplained jump in payable days.
In India
The statement of profit and loss follows Schedule III and has a prescribed structure: revenue from operations, other income, then expenses broken into cost of materials consumed, purchases of stock-in-trade, changes in inventories, employee benefits expense, finance costs, depreciation and amortisation and other expenses. Then profit before exceptional items and tax, exceptional items, tax, and profit for the period. Then other comprehensive income, and basic and diluted earnings per share.
Because it is prescribed, the layout is identical across companies. That is an advantage for comparison, and it means Indian companies do not have the freedom American companies have in grouping their costs.
Four Indian specifics.
A cash flow statement is required for most companies under Section 2(40) of the Companies Act 2013, with exemptions for one person companies, small companies and dormant companies. Almost all Indian companies use the indirect method, which is the more informative one for a reader.
Interest has a classification choice. Ind AS 7 permits interest paid to be classified in operating or financing activities. Check the accounting policy note before comparing operating cash flow across 2 companies.
Quarterly results are published under SEBI's listing regulations, with a limited review by the auditor rather than a full audit. Indian listed companies also publish a cash flow statement on a half-yearly basis. Segment reporting under Ind AS 108 splits results by business segment, using the segments management itself uses internally. This is called the management approach. It shows whether growth came from the good division or the poor one.
In the United States
American income statements are less prescribed. Companies group costs in their own way, most commonly as cost of revenue, research and development, sales and marketing, and general and administrative. That grouping is more informative than Schedule III for a technology company, and it makes cross-company comparison harder.
Three American specifics.
Both GAAP and non-GAAP figures appear. Companies present official GAAP results and also their own adjusted measures, such as adjusted EBITDA or adjusted earnings per share, which exclude items management considers unrepresentative. SEC rules require the GAAP figure to be given equal prominence and a reconciliation to be provided. Read the reconciliation. It is a list of what management would prefer you did not count, and share-based compensation is frequently the largest item on it. Share-based compensation is a real cost and it dilutes you.
Guidance. Most American companies forecast the coming quarter or year. There is no equivalent convention in India.
Segment reporting under ASC 280 uses the same management approach as Ind AS 108, which makes segment data one of the more comparable disclosures across the 2 countries.
Where they differ, and what that tells you
Two divergences change the numbers themselves, and 1 changes what you are told about them.
Inventory method. US GAAP permits LIFO. Ind AS does not. When input costs are rising, an American company on LIFO reports lower profit than an Indian company with an identical warehouse. Companies using LIFO disclose the LIFO reserve, which lets you adjust.
Development costs. Ind AS 38 requires development spending to be capitalised as an intangible asset once specified criteria are met, which raises profit in the year of spending and reduces it later through amortisation. US GAAP expenses most research and development immediately. The same work produces different profit in the 2 countries.
Exceptional items and non-GAAP measures do the same job differently. India puts a prescribed "exceptional items" line inside the audited statement of profit and loss. The United States has no such line for most purposes, and instead has a culture of non-GAAP adjusted measures presented alongside the official numbers.
What that tells you is where the pressure on the profit number is applied. In India it is applied inside the audited statement, on a line with a name, which you can count. In the United States it is applied outside the audited statement, in a press release and a reconciliation table, which you read against the GAAP figure.
Both are visible, and both need the same response. Find the official figure, find the adjustment, and decide whether the adjustment describes something that will genuinely not repeat. An item that has not repeated in 5 years probably will not. An item that has appeared 4 years running is a cost of doing business with a different label on it.
Carry this
- Profit is an opinion. Cash is a fact. Compare them over 3 years, not 1.
- The operating section of the cash flow statement is an itemised list of the difference between the 2.
- Count the exceptional items. An exception that appears every year is not an exception.