Once you understand how a company makes money, the next step is figuring out how much of that money actually stays in the business. This is where profitability and cash flow come in.
In finance, there is an old saying: “Revenue is vanity, profit is sanity, but cash is king.”
When evaluating a company’s income statement, you have to look at three key margins:
- Gross Margin: What is left after paying the direct costs to produce the product or service. High gross margins (usually above 60–70%) indicate strong pricing power and a differentiated product.
- Operating Margin: What is left after paying operating expenses like research and development, sales, and administration. This shows how efficiently management runs the core operations.
- Net Margin: The bottom line—what percentage of revenue turns into pure net income after taxes and interest.
However, accounting profit isn’t always the same as actual cash in the bank due to non-cash expenses like depreciation and timing differences in collections. That is why Free Cash Flow (FCF) is the ultimate metric. Free cash flow is the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. Companies that generate massive, growing free cash flow have the ultimate financial freedom: they can reinvest in growth, pay dividends, buy back shares, or acquire competitors without begging Wall Street for loans.