Notes: What's behind the financial statements

STEP 1Notes are the footnotes of financial statements

Like the small-print footnotes under a textbook's main text, each number in the financial statements carries a tag that says 'see Note X for details'.

Looking only at the balance sheet line 'borrowings KRW 2.1 billion', you cannot tell which bank lent it, at what interest rate, or until when. You also don't know what was pledged as collateral. The place that records these inside details is the notes. As you saw in Lesson 1, the notes are a formal component of the financial statements together with the balance sheet, income statement, cash flow statement, and statement of changes in equity. They are not attached reference material but part of the main body that the auditor also reviews.

The notes do two broad things. First, they break down the numbers in the main statements. They show how much of the KRW 900 million of inventories is raw materials and how much is finished goods, and on what terms the KRW 2.1 billion of borrowings is split into KRW 600 million short-term and KRW 1.5 billion long-term. Second, they give information that didn't make it into the main statements as numbers. Examples are lawsuits not yet settled, guarantees given on other companies' debts, and major events that occurred after the closing date. The second matters more to investors.

In an annual report, the notes are inside III. Financial Matters. On a consolidated basis they are 3. Notes to Consolidated Financial Statements, and on a single-company basis 5. Notes to Financial Statements (see the table of contents map in Lesson 5 and consolidated vs separate in Lesson 11). It is the longest section, so the knack is to open only the numbers you need rather than read from start to finish.

STEP 2Eight notes you must open

Don't be scared even if there are more than 30 notes. At first you only need to look at eight places.

Note numbers and names differ a little by company, but the topics covered are almost the same. The eight topics below are the ones most often used to find hidden risks. Tap the cards one by one to see what to check and what looks like a warning sign.

Among the eight, three deserve special attention. First, contingent liabilities and commitments. These are obligations you may have to pay 'if something happens', such as ongoing lawsuits and payment guarantees given for another company's debt. If the likelihood is high and the amount can be reliably estimated, they are recorded in the main statements as the provisions you saw in Lesson 8; otherwise they appear only in the notes. Second, related-party transactions. These are sales, purchases, and funding transactions with major shareholders or affiliates, and if they were made on terms different from those with outsiders, profit may be inflated or company money may leak out. Third, assets pledged as collateral. If a factory or deposit is pledged as collateral, it is the company's property on the books but cannot be freely sold or used.

Dark Cloud Electronics' hidden guarantee

Look again at the balance sheet of Dark Cloud Electronics (fictional). With assets of KRW 25 billion, liabilities of KRW 20 billion and equity of KRW 5 billion, it already received a warning in Lesson 10 for a 400% debt-to-equity ratio. But open the notes and there is more that the main statements didn't say. Tap the note cards one by one in the figure below.

The KRW 10 billion payment guarantee for affiliates is twice the KRW 5 billion of equity. If an affiliate can't repay its debt, Dark Cloud Electronics has to repay it instead, so in the worst case equity is wiped out and more (capital impairment in Lesson 9). The fact that KRW 4 billion of the KRW 7.5 billion in trade receivables is owed by affiliates also changes the meaning of 'surging receivables' you saw in Lesson 7. If many of the credit sales were made not to outsiders but within the family, you have to question whether that revenue really came from the market.

STEP 3Navigating a real notes index

Lay out the notes index of a real annual report and find which numbers hold the eight topics.

Find it yourself on DART

1. 1Open the annual report and expand III. Financial Matters → 3. Notes to Consolidated Financial Statements in the left-hand table of contents.
2. 2In the list of note numbers, look for words like 'contingent liabilities', 'related parties', 'segments' and 'events after the reporting period'.
3. 3If there is a number in the main statements you are curious about, go back to the matching line of the consolidated balance sheet or income statement and check the same note number.

The consolidated financial statement notes in the real report number 33, from Note 1 'General information' to Note 33 'Events after the reporting period'. The ones matching the eight topics include 2 (accounting policies), 12 (borrowings), 15 (provisions), 16 (contingent liabilities and commitments), 29 (segment reporting), 30 (related-party transactions) and 33 (events after the reporting period). Leases have no separate number in this report and are included within other notes. As the numbers and the way items are grouped differ by company, it is quicker to search by the words in the name.

Open Note 16, 'Contingent liabilities and commitments', and it says that this company has several lawsuits, disputes and regulatory investigations under way in the normal course of business, and that management judges the outcome will not have a material effect on its financial position. It goes on to give, in a table, the limits of its agreements with banks such as trade finance and loans secured by trade receivables (for example, a combined limit of KRW 23.5367 trillion with Woori Bank and 27 other banks). A limit is a 'door through which it can borrow', not money actually borrowed. So even in the same 'contingent liabilities' note, a large company's routine commitments and a guarantee worth twice equity like Dark Cloud Electronics' carry completely different weight.

Try it: reading a related-party transactions note

Of the eight topics, the one beginner investors skip most often is related-party transactions. This note collects transactions with parties close to the company, such as affiliates, the largest shareholder, and executives. Transactions with close parties may be priced or structured differently from the market, so if the numbers are large you must look into them. Suppose the notes of the fictional Dark Cloud Electronics look like the one below.

Unit: KRW 100 million. Dark Cloud Electronics and the two affiliates are fictional companies in this course. Real notes too are usually divided into 'sales, etc. / purchases, etc. / receivables / payables' and 'payment guarantees / collateral' tables.

Read the table through three ratios. First, the share of sales to affiliates. Of year-3 sales of KRW 24 billion, KRW 9 billion, about 37.5%, came from affiliates. That means over a third of the customers are 'one family', so if those affiliates' circumstances worsen, sales shake with them. Second, the share of receivables from affiliates. Of KRW 7.5 billion in trade receivables, KRW 4 billion, about 53%, is money to be received from affiliates. A receivables share (53%) larger than the sales share (37.5%) is a sign that affiliates are paying later than outside customers. You can see here why the collection period in Lesson 7 stretched to 114 days. Third, combined exposure from guarantees and receivables. Adding the KRW 4 billion to be received and the KRW 10 billion guarantee that it may have to repay on others' behalf gives KRW 14 billion, 2.8 times the KRW 5 billion of equity, tied up in one group of affiliates.

If all three ratios are high and growing every year, it is worth suspecting that sales and profit may have been inflated by transactions among affiliates rather than by real business. By contrast, Robin Bakery (fictional) has no subsidiaries (except the Robin Coffee scenario in Lesson 11), so this note holds little more than executive pay. Even for the same note, the criterion for judgment is not 'what is written' but 'how large it is and how it changes year to year'.

How to use it in investing

Not always. Many lawsuits or commitments in the notes are common at companies with a large business scale. The key is to compare the amounts with equity and revenue, and compare with last year's notes to see whether any items are new or have grown suddenly.