Financial statements are a company's health checkup

STEP 1Financial statements are a bundle of five sheets

When you get your health checkup results, several sheets come bundled together. Financial statements are the same. Let's start with what each sheet measures.

A company's health checkup

When checking a person's health, you don't just measure height and weight. You also test fitness and draw blood for a blood test, because each tells you something different. Companies are the same. Financial statements are a bundle of official report cards, written in a set format, about how the company did over the year, and Korean listed companies follow K-IFRS, the Korean translation of International Financial Reporting Standards. Among them, standard No. 1001, 'Presentation of Financial Statements', defines a complete set of financial statements as five parts.

K-IFRS No. 1001 calls the income statement the 'statement of comprehensive income', showing other comprehensive income as well below net income. In this course we call it the 'income statement' to keep it easy to understand.

The difference between a photo and a video

The first thing to tell apart among the five sheets is the 'photo' and the 'video'. The balance sheet is a photo taken on one specific day, such as Dec 31. It shows how much cash, how much factory and how much debt the company had that day. The income statement and the cash flow statement, by contrast, are a video shot over the year from Jan 1 to Dec 31. They record how much was sold and spent in between, and how much cash came and went.

Knowing this difference changes how you read the numbers. 'Cash of KRW 1 billion' on the balance sheet is only the balance on one day at year-end, while 'revenue of KRW 12 billion' on the income statement is the total accumulated over the year. So rather than comparing the two numbers directly, the basic approach is to compare like with like (last year-end vs this year-end, last year vs this year).

See it: tap the five sheets

Tap the cards one by one. They show what each statement displays and what an investor might look at first.

STEP 2The four tables are linked to each other

The five sheets are not separately written reports. Numbers from one sheet flow into another. Once you know these links, you can check for yourself whether the numbers add up.

Link 1: net income increases equity

Net income at the bottom of the income statement is the final result of a year of business. This profit belongs to shareholders, so after paying dividends, what remains builds up as retained earnings within equity on the balance sheet. If Robin Bakery earned net income of KRW 1.2 billion this year and paid KRW 300 million in dividends, equity rises by KRW 900 million, all else equal. The table that records this process line by line is the statement of changes in equity.

Link 2: the end of the cash flow statement is the balance sheet's cash

The cash flow statement starts from cash at the beginning of the year, adds and subtracts cash that came in and went out through operating, investing and financing activities, and ends with cash at year-end. This year-end cash must equal 'cash and cash equivalents' on the balance sheet. Robin Bakery earned KRW 1.8 billion from operations, spent KRW 1 billion on equipment and the like, and paid out KRW 400 million for dividends and debt repayment, so cash rose by KRW 400 million over the year.

See it: how the financial statements relate

Press the buttons. The lines light up to show which table a number flows from and to.

Profit and cash can differ

Robin Bakery's operating cash flow of KRW 1.8 billion is higher than its net income of KRW 1.2 billion. This is because depreciation on equipment such as ovens is deducted as an expense but no cash actually leaves. Conversely, if a company sells a lot on credit, revenue and profit are recorded but the cash has not yet come in. Having made a profit and having money in the bank are different matters, and this is the biggest reason to look at financial statements from three directions together. This difference is covered in detail in Part 4, the cash flow statement.

STEP 3Reading the Robin Bakery one-page summary

Now let's lay out, on one page, the three tables of the fictional company that will stay with you throughout this course. Every calculation from here on connects to these numbers.

This course's example company

Robin Bakery Co. is a fictional listed company that sells bread, cakes and coffee. We assume 2 million shares outstanding and a share price of KRW 9,000. Because numbers don't stick if every lesson uses a different example, this course calculates with one company's numbers from start to finish. If you tap a line on the card below, it shows the Part where you learn that number.

Once from each of three directions

This single page already outlines the company. On the balance sheet, of KRW 10 billion in assets, other people's money (liabilities) is KRW 4 billion and shareholders' money (equity) is KRW 6 billion, so debt is not excessive. On the income statement, it sold KRW 12 billion and kept KRW 1.5 billion from its core business (operating margin 12.5%). On the cash flow statement, the cash coming in from the core business (KRW 1.8 billion) is more than net income, so the profit on the books is backed by actual cash.

When the pictures from three directions tell the same story, a company is generally healthy. By contrast, the fictional company 'Dark Cloud Electronics', which you will meet later in this course, is profitable three years in a row, yet its operating cash flow is negative three years in a row. On the income statement alone it looks fine, but the other two tables are sending a warning.

How to use it in investing

In Economics Lesson 1 you learned that share price = EPS × PER. Robin Bakery's EPS is net income of KRW 1.2 billion ÷ 2 million shares = KRW 600, and at a share price of KRW 9,000 its PER is 15x. In this way, financial statements are the raw material that fills in the 'earnings (EPS)' in the share price formula (share price = EPS × PER). Fundamental investing is ultimately about checking for yourself whether this raw material is solid and whether it will grow.

Not always. Financial statements are a record of a past period and do not guarantee future results as they are. Also, the range of normal numbers differs by industry, so a bank and a manufacturer should not be judged by the same standard. This course does not recommend buying or selling any particular stock; it teaches how to read the numbers yourself.