The Corner Bakery has begun delivering breakfast orders to a nearby company. Sales are higher and the accounts show a profit. Yet, as payday approaches, the owner checks the bank balance with concern.
The customer will pay next month. Flour suppliers and employees need paying sooner.
This is how a profitable business can run short of cash. Financial statements show different parts of the same situation. We will concentrate on the income statement, balance sheet, and cash flow statement. Actual reporting also includes a statement of changes in equity and notes explaining accounting policies and important details. SEC guide to financial statements
The income statement: what the year earned
An income statement covers a period. It records revenue, expenses, and the resulting profit.
Here is an invented, simplified year for the bakery. All figures in this chapter are in millions of Korean won: 100 means KRW 100 million, and 10 means KRW 10 million.
| Item | KRW million |
|---|---|
| Revenue | 100 |
| Cost of sales | −60 |
| Gross profit | 40 |
| Other operating expenses | −25 |
| Operating profit | 15 |
| Interest expense | −3 |
| Tax expense | −2 |
| Net profit | 10 |
Revenue is not all available to the owners. Costs must be paid or recognized. After operating expenses, 15 remains. After interest and tax, net profit is 10.
The tax amount is invented, not an application of a particular tax rate. Presentation also varies with industry and accounting standards. Treat this as a readable model rather than a universal reporting template.
Margins help compare amounts of different sizes. Operating margin is operating profit divided by revenue: 15%. If sales later rise to 120 but operating profit falls to 12, the margin becomes 10%. The business sells more while retaining less from each unit of sales.
The balance sheet: what remains on one date
A balance sheet describes a point in time. It shows assets and how they are financed.
| Year-end asset | Amount | Financing source | Amount |
|---|---|---|---|
| Cash | 10 | Borrowings | 35 |
| Receivables | 18 | Payables | 15 |
| Inventory | 12 | Equity | 50 |
| Equipment, carrying value | 60 | ||
| Total assets | 100 | Total liabilities and equity | 100 |
KRW million; the same fictional company at year-end.
Receivables are amounts owed by customers. Payables are amounts owed to suppliers. Inventory includes items such as ingredients and finished goods awaiting sale. Book equity is the residual after liabilities are deducted from assets.
Assets of 100 = liabilities of 50 + equity of 50
Equity of 50 does not mean 50 sits in a separate bank account. The assets include customer promises and ovens as well as cash. Treating book equity as immediately spendable money would misrepresent the company’s ability to pay bills.
Asset quality matters too. Will customers pay on time? Is inventory perishable or obsolete? Could equipment be sold for its carrying value? The notes may provide the clues needed to investigate these questions.
Building a bridge from profit to cash
Net profit is 10, but suppose operating cash flow is only 5. A simplified reconciliation shows why.
| From profit to operating cash | KRW million |
|---|---|
| Begin with net profit | 10 |
| Add back depreciation | +5 |
| Increase in receivables | −8 |
| Increase in inventory | −4 |
| Increase in payables | +2 |
| Operating cash flow | 5 |
No other adjustments. Interest and tax payment timing and cash-flow classification are simplified to fit this example.
Depreciation spreads the cost of a long-lived asset across accounting periods. Recognizing depreciation expense of 5 does not mean an additional cash payment of 5 occurred this year. It is therefore added back in this reconciliation. Cash spent buying equipment is examined separately under investing activity.
Receivables increased by 8. More of the revenue recognized in the accounts remains uncollected. Inventory increased by 4, tying up more resources. Payables increased by 2, meaning some payment to suppliers was deferred and cash temporarily retained.
An increase in payables is not automatically good news. It may reflect normal negotiated terms or an inability to pay promptly. The number identifies a question; it does not answer it.
The cash flow statement reveals choices
The business generated 5 from operations, spent 12 on equipment, and borrowed another 8. With no other transactions, cash increased by 1.
Cash from operations +5
Equipment purchases −12
Additional borrowing +8
─────────────────────────────
Net increase in cash +1
Opening cash 9 → Closing 10
KRW million. Closing cash matches the balance sheet.
Part of the new equipment is financed through debt. That may be sensible if it creates capacity that earns sufficient cash. It may be troublesome if the bakery is adding ovens without enough customers.
A decline in cash, or an increase in borrowing, therefore needs context. Expansion and distress can produce superficially similar movements.
The numbers also connect across statements. Opening borrowings of 27 plus new borrowing of 8 gives closing debt of 35. Opening equipment of 53 plus purchases of 12 minus depreciation of 5 gives 60. Opening equity of 40 plus net profit of 10 gives 50, assuming no dividends, new shares, or other equity movements.
These connections make the accounts a system rather than three unrelated tables.
Turn one year into several years of questions
Do not try to master every line on the first reading. Start with revenue, operating profit, operating cash flow, and borrowings across several years.
Does the company repeatedly report profit without collecting much operating cash? Are receivables growing much faster than sales? Does a new facility produce the revenue management expected? These questions are more useful than deciding that one ratio must always be above a particular number.
A growing business may legitimately tie up cash in inventory and customer credit. Weak cash flow in one period is not proof of misconduct. Persistent weakness does justify closer examination of collection periods, customer concentration, credit quality, and financing needs.
Compare like with like. Consolidated statements treat the parent and controlled subsidiaries as an economic group; separate statements focus on the reporting company itself under the relevant framework. Mixing the two can create misleading changes. Match periods, units, and accounting bases as well. A quarter is not a year.
Industry context matters. Inventory is central to a bakery but may be minor for a software company. A bank’s balance sheet requires a different reading from a retailer’s. A helpful first framework should lead you toward those differences, rather than hide them.
For practice, open one company’s annual report and find where its revenue comes from and one large cash outflow. Beside the figures, write: who pays, when do they pay, and what must the company spend again to keep earning?
The breakfast contract remains good news for the bakery. It simply does not pay wages until the customer’s money arrives. Reading the statements together helps an owner, or a shareholder, see both facts at once.