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.
Before you startIn Lesson 18 you learned that a cake sold on credit counts as profit but not as cash, and in Lesson 19 how to calculate operating cash flow starting from net income. In Lesson 7 you saw Dark Cloud Electronics' receivables collection period stretch from 55 days to 114 days, and in Lesson 10 its debt-to-equity ratio of 400%. Today we continue to see how those numbers show up in the cash flow statement. We will also use FCF from the immediately preceding Lesson 20.
- STEP 1 · Basic conceptsProfit but no cash
Explain with the increase in why earnings and cash diverge when credit sales and inventory grow.
- STEP 2 · Understanding the mechanicsFollowing Dark Cloud Electronics for three years
Follow how net income of KRW 600 million, KRW 500 million and KRW 300 million and operating cash flow of −KRW 400 million, −KRW 1.5 billion and −KRW 2.2 billion are calculated, and read what was used to fill the gap.
- STEP 3 · Applying itReading the signs of insolvency despite profits
Check the warning signs of in order, using the cash flow statement, balance sheet and disclosures.
Building knowledge90 concepts built so far · 4 added in this lesson
Part 1 · Getting to know DART 23 ✓
The five financial statementsPhoto (balance sheet) vs video (income statement and cash flow)Net income → retained earningsEnding cash = balance sheet cashRobin Bakery example companyDisclosure: to all investors at the same timeDART (FSS electronic disclosure system)10 filing typesPeriodic vs timely disclosureDART and KIND3 DART search criteria (company name, period, filing type)Periodic disclosure → annual report filterFinal version and correction markersDocument table of contents and III. Financial MattersChecking table units and fiscal terms3 periodic reports (annual, semi-annual, quarterly)Filing deadlines: 90 days and 45 daysAudit and reviewPreliminary earnings → audit report → annual reportThe 12 chapters of an annual reportBusiness Overview and Financial MattersManagement Discussion and AnalysisThe 10-minute skim order
Part 2 · Balance sheet 27 ✓
Assets = liabilities + equityOther people's money vs your ownA transaction moves both sidesCurrent vs non-current (1-year line)Speed of turning into cashTrade receivables · inventoriesPP&E and depreciationDays sales outstandingCurrent vs non-current liabilities (1-year line)Interest-bearing debt (borrowings, bonds)Operating liabilities (trade payables, advances received)Lease liabilities · provisionsInterest expense and rate sensitivityEquity = assets − liabilities (shareholders' share)Share capital · capital surplus · retained earningsRetained earnings = opening + net income − dividendsCapital impairment ratio = (share capital − total equity) ÷ share capitalAdministrative issue (50%) · delisting (full impairment)Debt-to-equity ratio = liabilities ÷ equityCurrent ratio · quick ratio (ability to repay within a year)Borrowings to total assets and interest coverage ratioComparing with the industry averageConsolidated (whole group) vs separate (one company)Eliminating intercompany transactions and investment sharesNon-controlling interestEPS and ROE on the owners' shareHolding companies: read consolidated and separate together
Part 3 · Income statement 24 ✓
Income statement = a record of one year (a period)Five-step staircase of profitCost of goods sold vs SG&ARevenue = price × quantityGross margin · cost of sales ratioAmplifying effect of cost changesPricing power and pass-throughOperating profit = revenue − cost of goods sold − SG&AOperating marginFixed cost · variable costOperating leverageNon-operating income/expense (interest, translation, equity method, disposals)Pre-tax income and income taxFiltering out one-off gainsEarnings qualityProfit attributable to owners of the parentEPS = profit attributable to owners ÷ weighted average sharesBasic EPS · diluted EPSShare cancellation and EPSTrailing P/E · forward P/EQoQ vs YoYSeasonalityThree-month, year-to-date and implied Q4Preliminary earnings and consensus
Part 4 · Cash flow statement
Cash flow statement = a year of bank account recordsAccrual earnings vs actual cashNon-cash expenses (depreciation)Opening cash + three sections = closing cashOperating, investing and financing sectionsIndirect method: net income + non-cash expenses − increase in working capitalWorking capital (assets up, cash down; liabilities up, cash up)Reading company type from the sign patternFree cash flow (FCF)FCF yieldDividend coverageGrowth-investment vs weak-operations negative FCFInsolvency despite profitsNEWIncrease in working capitalNEWGap between earnings and cashNEWSurviving on debtNEW
STEP 1Profit but no cash
Let's start with a tiny shop to see how book profit and bank-account cash diverge.
Suppose a neighborhood stationery shop delivers KRW 10 million worth of notebooks to a school. The cost was KRW 7 million, so the books show a profit of KRW 3 million. But the school will pay in three months, and the shop already paid the wholesaler KRW 7 million to buy the notebooks. This month, the bank account did not grow by KRW 3 million; it shrank by KRW 7 million. If rent day arrives in this state, the shop may be unable to pay the rent despite being profitable on the books.
The moment a company fails is not "the day it posts a loss" but "the day it has no cash on the day payment is due." If it cannot pay in cash a bank loan maturity, supplier payments or employee wages, it defaults regardless of book profit. A company that collapses because cash dries up even though it earns profits is called .
The cause is mostly in . Working capital is the money tied up in running the business, typified by unpaid credit sales () and piled up in the warehouse. Subtract what you have not yet paid suppliers (trade payables) and you get the money that is purely tied up. It is natural for receivables and inventory to rise along with revenue growth, but if they grow far faster than revenue, cash keeps being sucked away by that amount.
Operating cash flow ≈ net income + depreciation − increase in working capitalRobin Bakery (fictional): KRW 1.2 billion + KRW 1.0 billion − KRW 0.4 billion = KRW 1.8 billion. Working capital grew by only KRW 400 million, so more cash was left than profit.
Quick checkA company with net income of KRW 1 billion and depreciation of KRW 500 million saw trade receivables and inventory grow by KRW 2 billion in a year. Roughly what is its operating cash flow?
About −KRW 500 million. KRW 1.0 billion + 0.5 billion − 2.0 billion = −KRW 0.5 billion. The books show a profit, but KRW 500 million of cash flowed out of the core business.
STEP 2Following Dark Cloud Electronics for three years
Now let's follow the fictional company Dark Cloud Electronics through three years of numbers. Watch how the profit line and the cash line pull apart.
Dark Cloud Electronics' revenue grew by KRW 1 billion a year, to KRW 20 billion, KRW 22 billion and KRW 24 billion, and net income was KRW 600 million, KRW 500 million and KRW 300 million, profitable all three years. On the surface it is a "steadily growing, profitable company." But as we saw in Lesson 7, trade receivables swelled from KRW 3.0 billion to 4.8 billion to 7.5 billion, and inventory from KRW 2.5 billion to 3.8 billion to 5.5 billion, far faster than revenue. It did sell goods, but did not get paid on time, and the goods it made piled up in the warehouse.
These are the numbers of the fictional company Dark Cloud Electronics. Unit: KRW 100 million. The working capital increase is assumed to be the sum of the increases in receivables and inventory (18, 31 and 44), depreciation is 8 each year, and the increase in trade payables and similar items is 0, 3 and 11. Click the points or bars.
| Dark Cloud Electronics (fictional, KRW 100 million) | Year 1 | Year 2 | Year 3 |
|---|
| Net income | +6 | +5 | +3 |
| + Depreciation (expense with no cash outflow) | +8 | +8 | +8 |
| − Increase in receivables and inventory | −18 | −31 | −44 |
| + Increase in trade payables and similar (delaying supplier payments) | 0 | +3 | +11 |
| = Cash flow from operating activities | −4 | −15 | −22 |
| − Capital expenditure | −5 | −6 | −5 |
| = FCF (Lesson 20) | −9 | −21 | −27 |
Reading the table from the top tells the story. Net income plus depreciation could have produced KRW 1.1–1.4 billion of cash each year, but receivables and inventory piled up by far more, so operating cash flow turned negative. In Year 3, it even delayed supplier payments (trade payables and similar +KRW 1.1 billion) to barely hold the line at −KRW 2.2 billion. Delaying payments is like temporarily borrowing another company's money, so if suppliers stop waiting, it leads straight to a cash shortage.
So where did the missing cash come from? On the balance sheet, short-term borrowings swelled to KRW 7 billion, and over two years the company issued three times, KRW 6 billion in total. Since the core business could not earn cash, it survived on debt and on "debt that may later turn into shares." In the real case in Lesson 20, the shortfall in a negative-FCF year was filled from accumulated cash, whereas Dark Cloud Electronics filled it with newly borrowed money. The two situations are completely different.
Common misconceptions
- "A profitable company never goes bankrupt?"
- A company repays its debts with cash, not profit. If it has no cash on the repayment date, it can default even if it is profitable.
- "Rising trade receivables mean business is doing well?"
- It is natural if they rise at about the same pace as revenue, but if they rise much faster than revenue, it may mean the company is not getting paid on time. Dark Cloud Electronics had trade receivables up 56% in a year when revenue was up 9%.
- "One year of negative operating cash flow is dangerous?"
- In a year when a big order was received and inventory was stocked up in advance, it can be temporarily negative. The problem is when it happens several years in a row and the gap with earnings keeps widening.
Quick checkDark Cloud Electronics' Year 2 net income is KRW 500 million, depreciation KRW 800 million, the increase in receivables and inventory KRW 3.1 billion, and the increase in trade payables and similar KRW 300 million. Can you work out how operating cash flow becomes −KRW 1.5 billion?
0.5 + 0.8 − 3.1 + 0.3 = −KRW 1.5 billion. The money tied up in working capital was far larger than the KRW 1.3 billion generated by profit and depreciation.
STEP 3Reading the signs of insolvency despite profits
Walk through the path along which cash disappears one step at a time, and summarize the signals you can spot in advance from disclosures and financial statements.
1 Credit salesRevenue grows and the books show profit
2 Money does not arriveTrade receivables pile up
3 Inventory piles up tooGoods made sit in the warehouse
4 Cash shortageOperating cash flow turns negative
5 Plugged with debtShort-term borrowing, CBs, delayed payments
6 Maturities bunch upDefault if it cannot repay
This is a simplified picture of the path along which cash disappears. In real companies, stages may overlap or occur in a different order.
Insolvency despite profits does not arrive overnight. It usually unfolds over several years in the order above, and each stage leaves traces in the financial statements or disclosures. Stages 1–3 show up in receivables and inventory on the balance sheet and in the collection period from Lesson 7; stage 4 in operating cash flow in the cash flow statement; and stage 5 in the financing section, short-term borrowings, and convertible bond issuance disclosures (material event reports). By stage 6, it is already too late. That is why investors need the habit of looking at the earlier signals together.
Find it yourself on DART
In the annual report, under III. Financial Matters → 2. Consolidated financial statements → Consolidated cash flow statement, write the top line "Cash flows from operating activities" and the "Net income" below it side by side for three years. See whether the gap between them widens each year. If the line for "changes in operating assets and liabilities" in the same table (called "changes in working capital" or similar at some companies) is a large negative, check the changes in receivables and inventory in the notes. Finally, choose "Material event report" in the disclosure search and count how many convertible bond issuance decisions there have been (choosing filters, as in Lesson 3).
How to use it in investing
| Check order | Warning sign | Dark Cloud Electronics |
|---|
| 1. Net income vs operating cash flow (3 years) | Profitable but operating cash flow negative for consecutive years | +6·+5·+3 vs −4·−15·−22 |
| 2. Receivables and inventory vs revenue growth | Growth far faster than revenue | Revenue +9%, receivables +56% (Year 3) |
| 3. What the financing inflows really are | Repeatedly plugged with short-term borrowing and CBs | Short-term borrowings KRW 7 billion, 3 CB issues totaling KRW 6 billion |
| 4. Maturities and disclosure history | Short-term debt concentration, frequent CBs, corrections and auditor changes | Current ratio 93%, auditor change |
This is not always the case. A fast-growing company sees receivables and inventory rise first, so operating cash flow can be weak for a while, and in order-based industries payments are bunched at certain times and swing from year to year. Look at whether several signals point in the same direction rather than just one, and how many years that state continues. This checklist is a list of items to check and is not a basis for investment decisions.
Quick checkCompany A had negative operating cash flow for two years in a row but covered it with cash on hand, while Company B covered the same period by issuing CBs three times. Which calls for more caution?
Generally Company B. Covering a shortfall with accumulated cash uses up financial strength, but repeatedly issuing CBs means taking on new debt and possibly diluting shareholders. When maturities or conversions bunch together, the burden grows all at once.