Net income is the number the market obsesses over. It’s also the one most likely to mislead you — and learning to see past it is one of the most important skills you can develop as an investor.
In Part 1, we started where the professionals start: the cash flow statement. We looked at why free cash flow tells you more about a business than the headline profit number, and how a company can be profitable on paper while quietly burning cash.
Now we turn to the statement most investors start with — and often should trust the least.
The income statement — also called the profit and loss statement, or P&L — shows how much money a business made during a period. It starts with revenue at the top, subtracts costs, and arrives at net income at the bottom. It’s the most widely reported, most widely debated financial document a company produces.
It’s also built on accounting rules that create real distance between the numbers and the actual economics of the business. This post shows you how to navigate that distance — and where to look when the headline number isn’t telling the whole story.
The Income Statement, Line by Line
The income statement flows from top to bottom: every line follows logically from the one above it. Here’s the structure, and what each line actually measures.
Revenue — also called sales or the top line — is how much the business collected (or is owed) from customers during the period. This is the starting point for everything else.
Cost of goods sold (COGS) is what it cost to produce the products or services that generated that revenue. For a manufacturer, it includes raw materials, direct labor, and factory overhead. For a software company, it’s mostly hosting costs and direct delivery. Subtract COGS from revenue and you get gross profit.
Operating expenses cover the cost of running the business beyond production: marketing teams, accounting departments, executive salaries, office rent, research. Also called SG&A (selling, general and administrative expenses) or R&D in businesses that invest in product development.
Subtract operating expenses from gross profit, and you arrive at operating income — also called EBIT (Earnings Before Interest and Taxes). This is the most important number on the income statement for an investor, and we’ll come back to it in detail.
Interest expense — the cost of carrying debt — is the next deduction. A company that borrowed money to finance its business pays interest to its lenders; that cost reduces income below the operating line. Subtract interest from operating income and you get pre-tax income (also called EBT, Earnings Before Taxes).
Finally, subtract taxes, and you arrive at net income — the bottom line.
So the full flow looks like this:
Revenue
− Cost of Goods Sold
= Gross Profit
− Operating Expenses
= Operating Income (EBIT)
− Interest Expense
= Pre-Tax Income (EBT)
− Taxes
= Net IncomeEBIT is the midpoint of that journey — what the business earns from its operations, before interest and taxes enter the picture. You go from EBIT to net income by subtracting those two items. The name says it directly: Earnings Before Interest and Taxes.
Why Investors Should Start with Operating Income — Not Net Income
Here is the investor’s lens on the income statement, stated plainly:
Net income combines two things: the performance of the business, and a set of financial and tax decisions that have nothing to do with how well the business serves its customers. You want to see the business first.
Consider what happens below the EBIT line. Interest expense depends entirely on how much debt the company has chosen to carry. That’s a financing decision — not a measure of whether the business is good at what it does. Two companies with identical operations but different capital structures (one debt-heavy, one funded primarily by equity) will report identical operating income and wildly different net incomes. Judge them on net income and you’d conclude one is dramatically worse when the underlying business is the same.
Tax rates vary by jurisdiction, by structure, by deferred tax accounting, and by one-time tax benefits or write-downs that have nothing to do with operations. A genuinely strong business can report a terrible year because a deferred tax asset got written off. A mediocre business can look excellent because a one-time tax ruling padded the bottom line.
Stop at operating income (EBIT) and both of those variables disappear. EBIT is what’s left after the business covers all of its operating costs — but before lenders and governments take their share. It’s the cleanest measure of what the core business is actually earning.
When analysts compare companies across industries, across countries, or across different levels of debt, they almost always anchor on EBIT (or multiples of it, like EV/EBIT). For good reason: it’s the number that’s comparable. Net income often isn’t.
EBIT vs. EBITDA — Why the Extra Letters Are a Problem
You’ll hear EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) constantly in financial reporting. It’s marketed as an even cleaner version of EBIT — one that adds back the non-cash charges for depreciation and amortization, getting you closer to actual cash.
The logic sounds reasonable. Depreciation and amortization are accounting entries, not cash payments. The cash for that equipment left the building when it was purchased, not spread over the following decade in small accounting increments. So why not add it back?
Because depreciation reflects something real: assets wear out. A manufacturer’s machines break down. A restaurant chain’s kitchen equipment needs replacing. A delivery company’s fleet ages and eventually stops running. Adding back the depreciation charge doesn’t make the eventual replacement less inevitable. When it’s time to replace that equipment, the company will need to spend real cash — a lot of it.
EBITDA says: ignore the wear-and-tear charge. It doesn’t say: ignore the fact that the wear is happening.
Charlie Munger — Warren Buffett’s longtime partner at Berkshire Hathaway — put it memorably at Berkshire’s annual meetings: “Every time you see the word EBITDA, you should substitute the words ‘B.S. earnings.’” (He used the actual word, not the initials. The contempt was deliberate.) The depreciation being “added back” represents capital that will have to be replaced. Pretending it doesn’t exist produces a number that flatters the business’s earnings power, especially for capital-intensive companies.
The practical rule: anchor on EBIT. If you see EBITDA reported, subtract the depreciation and amortization back out and verify you get EBIT — that’s the number that matters. And remember that even EBIT doesn’t fully capture what the business earns for you, because some capital spending is required just to keep the business at its current size. (Part 1 covered the distinction between maintenance and growth capex, and why that separation matters.)
How Operating Income Connects to Intrinsic Value
This is the connection that makes the income statement actually useful for an investor: EBIT is the starting point for the valuation math we use throughout the Intrinsic Value series.
When we calculate the intrinsic value of a business, we’re estimating what it’s worth based on the free cash flow it will generate. That process begins with EBIT:
EBIT → NOPAT → Free Cash Flow to the Firm (FCFF) → Discounted to Present ValueNOPAT (Net Operating Profit After Tax) is simply EBIT adjusted for taxes — the after-tax return the business generates purely from operations, before any financing choices affect it. You calculate it as:
NOPAT = EBIT × (1 − Tax Rate)NOPAT then gets adjusted for depreciation, capital expenditures, and changes in working capital to produce FCFF (Free Cash Flow to the Firm) — the cash the business generates for all of its capital providers. That’s the number we discount to arrive at intrinsic value.
If you’ve read the Intrinsic Value series, you’ve already done this math. Part 4 builds the FCFF formula step by step. Part 7 assembles the complete model. The income statement is where that chain starts — EBIT is the first number you pull, and everything else follows from it.
This is why understanding the income statement well enough to read EBIT correctly matters so much. If you misread EBIT — if you use a number distorted by one-time items, or confuse gross profit with operating income — you’re building your valuation on a flawed foundation.
A Few More Items Worth Watching
Two more things on the income statement that are worth a regular check.
Non-recurring items. Companies often report “adjusted” or “non-GAAP” earnings that exclude charges they’ve labeled one-time: restructuring costs, impairment write-downs, gains on asset sales, litigation settlements. Sometimes that framing is fair — a genuine one-time event distorts a single year’s picture. But if a company takes “non-recurring” charges every two or three years, those charges are not non-recurring. They’re recurring costs the company is choosing not to count. Look at five or ten years of history: if the pattern repeats, treat those costs as ongoing expenses, not exceptions.
Gross margin. Gross profit divided by revenue, expressed as a percentage. A high, stable gross margin — 60%, 70%, 80% — means the business has pricing power: it can charge meaningfully more than its direct production costs. A low or falling gross margin means competition is squeezing the business from the top. What you’re watching is the trend, not just the level. A company whose gross margins are declining year after year is losing pricing power, even if the revenue line is growing. That’s a warning sign that the business’s core competitive position is eroding.
A Note to Luca and Lili
The income statement looks simple. Revenue minus costs equals profit. You could learn the arithmetic in ten minutes.
What takes years is learning which profit number actually tells you something about the underlying business, and which numbers are shaped by financing decisions, tax strategies, and accounting rules that have nothing to do with whether the company is genuinely creating value.
Start by learning the structure from top to bottom — and knowing exactly what each subtraction represents before you look at the final number. The bottom line is a summary. The real information lives above it.
— Papa
The One-Paragraph Summary
The income statement flows from revenue at the top down to net income at the bottom. The key midpoint is operating income (EBIT) — what the business earns after all operating costs, but before interest expense and taxes are deducted. Investors focus on EBIT rather than net income because interest and taxes reflect financing decisions and jurisdictional differences that say nothing about the underlying business’s performance. EBITDA — which adds back depreciation and amortization — is a commonly cited but misleading metric: depreciation represents real asset wear that will require real capital to replace, and pretending otherwise systematically overstates the earning power of capital-intensive businesses. Beyond EBIT, watch gross margin as a measure of pricing power and look critically at any “non-recurring” charges that seem to recur regularly. Most importantly: EBIT is where the intrinsic value calculation starts — it feeds directly into the FCFF formula that drives the discounted cash flow models covered in the Intrinsic Value series.
Next: Part 3 — The Balance Sheet: What Actually Matters. The income statement tells you what the business earned. The balance sheet tells you what the business is built on: the assets it owns, the obligations it carries, and whether the foundation underneath those earnings is as solid as the reported numbers suggest.
— Jim