Part 7 · In practice: reading and judging for yourself · Lesson 35
Practice: a sturdy company vs. a risky company
Looking at net income alone, both are profitable companies. Lay five statements side by side and you see completely different companies.
QToday's question
Both have been profitable for three years in a row, and one has a P/E of only 8x, so it looks cheaper. Have you really found a cheap company?
In the checklist in Lesson 34, six boxes lit up for Dark Cloud Electronics. Today we confirm the reasons with actual numbers. We lay out the five statements you have learned since Lesson 1 for both companies in the same way, and hunt like a detective for where the gap opens up.
MAPLearning map for this lesson
We build it up in three steps. At the end of each step, a 'Quick check' lets you test your understanding before moving on.
In Lesson 34 we bundled ten red flags into a checklist. Every number used today has been calculated once before: the debt-to-equity ratio, current ratio and interest coverage ratio from Lesson 10, net income vs operating cash flow from Lesson 21, accruals from Lesson 22, ROE from Lesson 23, payment guarantees from Lesson 29, and CB dilution from Lesson 31. All of them come together in one place.
- STEP 1 · Basic conceptsOn net income alone, they are twins
You will be able to explain why net income, EPS and P/E alone make it hard to see the difference between the two companies, and why a low P/E can be a trap.
- STEP 2 · Understanding the mechanicsPutting the five statements side by side
You will be able to find the differences between the two companies across five tabs (balance sheet, income, cash flow, ratios, disclosures) and link each to the lesson where the concept was taught.
- STEP 3 · Real-world applicationWriting a conclusion in a detective's notebook
You will be able to answer eight questions, find the supporting line for each, and write a three-line conclusion grounded in the numbers.
STEP 1On net income alone, they are twins
Read each company's résumé one line at a time and both look fine. That is exactly the trap.
An easy analogy · Two households' account books
Both households say, 'We were in the black again this year.' One gets a salary paid into its account and is paying down its loan bit by bit. The other has money owed to it that exists only on paper, and covers living expenses with card loans. The paper profit is the same, but look at the bank account and the debt, and they are completely different households.
First impression: both profitable for three years in a row
Net income KRW 0.7 → 0.9 → 1.2 billion
EPS KRW 600 · Share price KRW 9,000 · P/E 15x
Net income KRW 0.6 → 0.5 → 0.3 billion
EPS KRW 300 · Share price KRW 2,500 · P/E about 8.3x
Looking only at the bottom line of the income statement, both companies made a profit all three years. Dark Cloud Electronics actually has twice the revenue, and its P/E of about 8.3x is little more than half of Robin Bakery's 15x. By the logic of Lesson 16, it looks like 'a company where you can buy the same earnings more cheaply'. Its P/B of 0.5x is also the 'company trading below its equity' we saw in Lesson 24.
But the direction of net income already gives a hint. Robin Bakery's net income grew every year, while Dark Cloud Electronics' fell from KRW 600 million to KRW 300 million even as revenue grew. If profit shrinks while revenue grows, somewhere costs or burdens are growing. Finding where is today's job.
Quick checkDark Cloud Electronics' revenue grew 20% but its net income was cut in half. What are the first two places to look?
STEP 2Putting the five statements side by side
Now we lay out the five statements in the same order. Tap a row to see why the gap exists and in which lesson it was taught.
dashboard · year 3 basis (unit: KRW 100 million, all fictional)
| Item | Robin Bakery | Dark Cloud Electronics | Taught in |
|---|
Tap a row.
Balance sheet: big in size, but mostly other people's money
Dark Cloud Electronics' assets are KRW 25 billion, two and a half times Robin Bakery's (KRW 10 billion). But KRW 20 billion of that is liabilities and equity is only KRW 5 billion, so its is 400%. Robin Bakery's is about 67%. The makeup of the assets differs too. Of Dark Cloud's KRW 14 billion of current assets, receivables (KRW 7.5 billion) and inventory (KRW 5.5 billion) account for KRW 13 billion, and cash is only KRW 500 million. Debts due within a year (current liabilities of KRW 15 billion) exceed assets that will turn into cash within a year, so its is 93%, below 100%.
Income: revenue grows, but interest eats into profit
Dark Cloud Electronics' operating profit fell for three straight years, from KRW 1.2 billion to 1.0 billion to 0.8 billion, and its operating margin dropped to 3.3% in year 3. Because of its growing debt, interest expense rose from KRW 0.4 billion to 0.45 billion to 0.5 billion. As a result, its , which shows how many times operating profit can cover interest, is 1.6x, no comparison to Robin Bakery's 15x. It is a structure where even a small drop in operating profit makes interest hard to bear.
Cash flow: where the gap is widest
The cash flow statement is where the difference shows up most. Robin Bakery earned more cash than its net income (operating cash flow of KRW 1.8 billion, 1.5 times net income), spent KRW 800 million on equipment, and still had KRW 1 billion of left over. With that, it paid KRW 300 million in dividends and repaid KRW 100 million of debt. Dark Cloud Electronics has operating cash flow of −KRW 2.2 billion, so its free cash flow is −KRW 2.7 billion, and it plugged that hole with KRW 2.5 billion of convertible bonds and short-term borrowings. By the from Lesson 22 (net income − operating cash flow), Robin Bakery is −KRW 600 million and Dark Cloud Electronics is +KRW 2.5 billion.
Disclosures: differences beyond the numbers
The last tab shows differences beyond the numbers. Robin Bakery has had no funding disclosures in three years and its audit opinion is unqualified. Dark Cloud Electronics issued convertible bonds three times in two years (KRW 6 billion), changed auditors, and, as seen in Lesson 29, has in its notes a KRW 10 billion on affiliate borrowings and a KRW 3 billion damages lawsuit. Adding the guarantee to the KRW 20 billion of liabilities on the balance sheet gives KRW 30 billion of potential burden, six times equity. As the convertible bonds turned into shares, the largest shareholder also changed to an investment partnership (Lesson 32), and three corrected filings came out in the same year (Lesson 33).
Common misconceptions
- "A company with bigger revenue is sturdier?"
- Dark Cloud Electronics' revenue is double, but a large part of it is receivables not yet collected in cash. Look not at size but at how fast revenue turns into cash (days sales outstanding of about 30 days vs 114 days).
- "A P/B of 0.5x means buying assets at half price?"
- The KRW 5 billion of equity is the figure if receivables of KRW 7.5 billion and inventory of KRW 5.5 billion are received at book value. If the receivables cannot all be collected or inventory has to be sold cheaply, equity could be much smaller (adjusted BPS in Lesson 24).
- "Both have an unqualified audit opinion, so there is no difference?"
- An unqualified opinion means 'prepared in accordance with accounting standards', not a guarantee that the company is 'safe'. When disclosures such as an auditor change and payment guarantees appear together, read carefully (Lesson 30).
Quick checkIf Dark Cloud Electronics' operating profit falls from KRW 800 million to KRW 500 million and interest expense stays at KRW 500 million, what would the interest coverage ratio be?
STEP 3Writing a conclusion in a detective's notebook
Now it's your turn to be the detective. For each question, pick the line that serves as evidence. When you choose an answer, that row is highlighted in yellow on the dashboard above.
Detective's notebook · eight questions
Writing the three-line conclusion
After finishing the detective's notebook, write your conclusion in three lines. A good conclusion does not say 'cheap/expensive' but records which line you based what on and what you confirmed. For Dark Cloud Electronics (fictional), it could read like this.
| Box | Sample memo |
|---|---|
| What did I see? | Profitable three years in a row, but operating cash flow of −KRW 0.4 → −1.5 → −2.2 billion. Receivables KRW 3.0 → 7.5 billion (collection period 114 days). |
| How is it getting by? | Plugs the cash shortfall with 3 CBs (KRW 6 billion) and short-term borrowings. Debt-to-equity ratio 400%, interest coverage ratio 1.6x, KRW 10 billion payment guarantee for affiliates. |
| What to check next | Whether next quarter's receivables are actually collected, whether CB conversion raises shares to 2.2 million, and whether a going-concern paragraph is added to the audit report. |
The memo for Robin Bakery (fictional) points the other way: 'Operating cash flow exceeds net income (1.5x), and free cash flow of KRW 1 billion covers both dividends and repayment. Debt-to-equity ratio about 67%, interest coverage ratio 15x. Next, check whether a P/E of 15x is reasonable relative to growth (revenue growth of around 9% a year).' It is good to note that even for a sturdy company, whether the price is right is a separate question.
The same order for real companies
Open a real company's annual report and there seem to be far more numbers, but the order is the same. 1 Look at three years of net income and equity in the Section III summary financial information, 2 write operating cash flow from the consolidated cash flow statement next to net income, 3 look at the makeup of liabilities and current assets on the balance sheet, 4 calculate five ratios (debt-to-equity ratio, current ratio, interest coverage ratio, ROE, days sales outstanding), and then 5 check funding, auditor and payment guarantees in the disclosure list and notes. In the next lesson, we apply this order as is to the real reports of SK Hynix and Kookmin Bank.
How to use it in investing
| When you hear this | Table to open first |
|---|---|
| "P/E of 8x, undervalued profitable company" | Three years of operating cash flow in the cash flow statement, and accruals |
| "Revenue growing 20% every year" | Whether receivables and inventory are growing faster than revenue; days sales outstanding |
| "Assets are 10 times the market cap" | How much of those assets were built with debt (debt-to-equity ratio), and the makeup of the assets |
| "Raising new funds to invest for growth" | The number of recent CB and rights offerings, the purpose of the funds, and the share count after dilution |
Robin Bakery and Dark Cloud Electronics are fictional companies made for education. Real companies sit somewhere between the two extremes, and one or two numbers cannot settle a conclusion. This lesson does not recommend buying or selling any particular stock.
Quick checkA company has a P/E of 6x, operating cash flow above net income for three straight years, and a debt-to-equity ratio of 50%. Is it likely to be a low-P/E trap?
✓What we learned today
- Robin Bakery and Dark Cloud Electronics (both fictional) look the same in that both have three straight years of profit. Dark Cloud Electronics even looks cheaper, with a P/E of about 8.3x versus Robin Bakery's 15x.
- The gap is widest in the cash flow statement. Robin Bakery's operating cash flow is +KRW 1.3 → +1.5 → +1.8 billion, while Dark Cloud Electronics' is −KRW 0.4 → −1.5 → −2.2 billion.
- Their staying power differs on the balance sheet with a debt-to-equity ratio of about 67% vs 400% and a current ratio of 150% vs 93%, and on the income statement with an interest coverage ratio of 15x vs 1.6x.
- Disclosures show differences beyond the numbers. Dark Cloud Electronics has three CBs (KRW 6 billion), an auditor change, and a KRW 10 billion payment guarantee for affiliates.
- Write your conclusion not as 'cheap/expensive' but as a three-line memo noting the lines that served as evidence. For real companies, you can lay out the statements in the same order.
Now that you have practiced on fictional companies, it's time to open real reports. In the next lesson, we read the real annual reports of SK Hynix and Kookmin Bank together, in table-of-contents order.
Quiz5-question quiz
Pick an answer and it's graded right away with an explanation.
Q1. When comparing Robin Bakery (P/E 15x) and Dark Cloud Electronics (P/E about 8.3x), which statement fits best?
Dark Cloud Electronics' net income does not arrive as cash (operating cash flow of −KRW 2.2 billion), so its earnings quality is low. A low P/E can be a value trap.
Q2. Which statement shows the biggest gap between the two companies?
Both have a net profit, but operating cash flow is exactly opposite: +KRW 1.8 billion for Robin Bakery and −KRW 2.2 billion for Dark Cloud Electronics.
Q3. What does Dark Cloud Electronics' current ratio of 93% mean?
Current ratio = current assets ÷ current liabilities. 140 ÷ 150 ≈ 93%, so short-term assets cannot fully cover short-term debt.
Q4. Which burden at Dark Cloud Electronics did not appear on the balance sheet and could be found only in the notes?
A payment guarantee is not recorded as a liability on the balance sheet until the company actually has to repay the money on someone's behalf. As in Lesson 29, look for it in the notes.
Q5. After finding a sturdy company, what question is left at the end?
Sturdiness and price are separate matters. For Robin Bakery too, separately check whether a P/E of 15x is reasonable relative to its growth rate.
NextTerms · Next lesson · Related tools
A method of laying out two companies' balance sheets, income statements, cash flow statements, ratios and disclosures in the same order and comparing them line by line. It uncovers the differences between companies that look similar on a single line (net income).
Cash flow from operating activitiesCash flow from operating activitiesThe cash that actually came in and went out from the core business, such as selling products and paying for materials, wages and taxes. Whether it is consistently positive is the basic check on a company's strength.
Free cash flow (FCF)Free Cash FlowOperating cash flow minus capital expenditure (acquisition of tangible assets). It's the cash left after making the investments needed to keep the business running, and it is the source of dividends, buybacks, and debt repayment.
AccrualsAccrualsNet income minus operating cash flow. It means the part of profit that has not yet come in as cash, and if it is large and keeps growing over several years, it is a signal to question earnings quality.
Debt-to-equity ratioDebt-to-equity ratioLiabilities ÷ equity. It shows how much must be repaid per KRW 100 of shareholders' equity. Averages differ greatly by industry, so compare within the same industry.
Current ratioCurrent ratioCurrent assets ÷ current liabilities. It shows how many assets that turn into cash within a year there are relative to debt due within a year.
Interest coverage ratioInterest coverage ratioOperating profit ÷ interest expense. It shows how many times the core business can pay the interest. Below 1x means it can't even pay all the interest.
ROE (Return on Equity)Return on EquityNet income divided by net assets (equity), showing how much shareholders' money earns in a year. The relationship PBR = PER × ROE links the two multiples.
P/EPrice-Earnings RatioShare price ÷ EPS. A multiple showing how many times one year's earnings the market pays for a share. It varies greatly with interest rates and investor sentiment.
P/BPrice-to-Book RatioShare price ÷ book value per share (BPS). It shows how many times the company's book net assets the stock trades at.
Value trapValue trapA case where P/E and P/B look cheap, but earnings are going to fall or profitability is low, so the low multiple is justified. It often appears at the earnings peak of cyclical industries.
Trade receivablesTrade receivablesMoney owed for goods or services already sold but not yet received. If it grows much faster than sales, it can be a sign the company isn't getting paid.
Days sales outstandingDays sales outstandingTrade receivables ÷ sales × 365. It shows the average number of days it takes to receive cash after a sale.
Convertible bond (CB)Convertible BondA corporate bond with the right to convert into the company's shares at a set price. The company can borrow at a low interest rate, but when it converts into shares, existing shareholders' stakes are diluted. Repeated issuance can be a sign of cash shortage.
Payment guaranteePayment guaranteeA promise to repay on another company's behalf if that company cannot repay its debt. Because it is not a confirmed debt, it is mainly written in the contingent liabilities and commitments in the notes, and the risk is judged by its size relative to equity.
Change of auditorChange of auditorWhen the accounting firm that performs the company's external audit changes. You can see recent auditor history in Section V of the annual report, and frequent changes are read as a signal to check whether the company is looking for an auditor who will give an opinion more easily.
Insolvency despite profitsInsolvency despite ProfitsWhen a company that shows profit on its books goes under because it lacks cash on the day debts or payments are due. It tends to happen when trade receivables and inventories pile up and operating cash flow stays negative.
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