What is net income?

Net income is found on a company's income statement.

The income statement is one of the three financial statements investors must understand in order to analyze businesses.

The purpose of the income statement is to show whether a company is profitable by showing its operating results over a period of time.

You can think of the income statement as your household budget.

If you were to look at your monthly budget, you would start by showing how much money you make from your job or other sources. Then, you'd subtract the expenses that you accrue during the month. The result? Your savings rate. With a company, the income statement follows a similar model.

Notably, the income statement uses accrual accounting. This means revenue & expenses are recorded when a transaction occurs, regardless of whether a payment has been made.

The income statement provides three crucial figures for investors:

1. Revenue: Total sales
2. Expenditures: Total costs and expenses
3. Income: How much profit was generated

A company's revenue, or sales, is all the money it makes by selling its products and services.

The company's expenditures, such as supplier costs and employee salaries, are subtracted.

The result is a company's net income expressed as a profit (if a surplus amount is left over) or loss (if its expenses exceed its sales).

What is free cash flow?

Free cash flow is found using the cash flow statement.

The purpose of the cash flow statement statement is to track cash movement. It shows how cash moves through a company over a period of time, such as a quarter or year.

A company’s cash flow statement can be compared to your personal checking account. It doesn’t care about transactions of goods and services being sold or when sales contracts are signed. It only tracks when money is deposited or withdrawn from a company’s bank accounts.

Cash flow statements use cash accounting, not accrual accounting.

The cash flow statement begins with net income as its input before non-cash charges are added back. These charges were accounted for on the income statement but where no cash exchanged hands.

This commonly includes four things:

1) Amortization - The gradual writing off of an intangible asset, similar to paying more interest at the start of a mortgage.

2) Depreciation - The gradual writing off of a tangible asset, such as the value of your car decreasing over time.

3) Stock-based compensation - Compensating employees with stock instead of cash.

4) Asset impairment - When the market value of an asset is less than previously stated and is written down, such as a company admitting it paid too much for an acquisition.

All of these charges are accounted for on the income statement (though they are not always broken out), but none of them involve cash leaving a company’s bank account.

Changes in working capital are the next thing that must be accounted for before arriving at operating cash flow. These are the difference between current assets and current liabilities (both from the balance sheet). This can include accounts receivable (e.g., when someone pays for a good or service using credit), inventory that has yet to be sold, or prepaid expenses.

After accounting for non-cash charges and changes in working capital, this gives us operating cash flow. It is the cash generated from normal business operations, similar to net income from the income statement on a cash basis.

Free cash flow results from subtracting capital expenditures (CapEx) from operating cash flow. CapEx are funds a company uses to build new or maintain existing physical assets, such as factories, equipment, and machinery.

In other words, free cash flow measures the amount of cash a business generates (using cash accounting) after subtracting all operating expenses and capital expenditures.

Key Takeaway

Net income and free cash flow are key metrics for evaluating a company's financial health, though they serve different purposes.

Net income, found on the income statement, shows profitability using accrual accounting, which tracks revenues and expenses when transactions occur.

Free cash flow, derived from the cash flow statement, measures cash generated after operating expenses and capital expenditures, offering a real-time view of cash movement using cash accounting.

Together, these metrics provide investors with a comprehensive picture of a company's performance, combining profitability with cash management efficiency.