This is the original lesson text as written at the time. Its examples, explanations and review questions are preserved and do not describe current market conditions.

Daily Economics, Business and Finance Study

September 27, 2026 (KST) · Day 7
Today's topic: How the Three Financial Statements Connect — Movements in Net Income, Retained Earnings, Cash and Borrowings

1. Review of the previous lesson

In Day 6, we learned to calculate FCF by subtracting CapEx from operating cash flow, and to distinguish whether low current FCF reflects growth investment or weak operations. Today, one example brings together how the numbers in the income statement, balance sheet and cash flow statement connect.

2. Today's core concepts

The three financial statements are not independent tables.

Income statement: How much the company earned over a period
Balance sheet: The resulting balances of assets, liabilities and equity
Cash flow statement: Why opening cash changed to closing cash

The most important connections are as follows.

Starting item	Connected item
Net income on the income statement	Starting point for OCF on the cash flow statement
Net income − dividends	Increase in retained earnings on the balance sheet
Depreciation	Income statement expense, OCF add-back and reduction in PP&E
CapEx	Investing cash outflow and increase in PP&E
Borrowing and repayment	Financing cash flow and balance-sheet borrowings
Sum of the three cash flow categories	Change in cash on the balance sheet

If the three financial statements do not reconcile correctly, the period, units, consolidation scope, signs or calculations are likely to be wrong.

3. Concepts explained

3-1. Net income on the income statement connects to two places

Net income first becomes the starting point of the operating activities section of the cash flow statement.

\[ OCF = \text{Net income} +\text{Non-cash expenses} -\text{Non-cash income} \pm\text{Working capital adjustments} \]

At the same time, net income increases retained earnings within equity on the balance sheet.

In simplified form:

\[ \text{Closing retained earnings} = \text{Opening retained earnings} +\text{Net income} -\text{Dividends} \]

Actual disclosures may also include equity adjustments, accounting policy changes, error corrections, changes in control and other items. Check the statement of changes in equity for the exact movements.

Important distinction

Net income earned → retained earnings increase
Dividends paid → retained earnings and cash decrease
Dividends are not an income statement expense

Dividends distribute profits already earned to shareholders, so they are not an expense deducted when calculating net income.

3-2. Why net income differs from the increase in cash

Net income includes expenses and income without actual cash movements. Revenue and expense recognition may also occur at different times from cash collection and payment.

Typical differences include the following.

Item	Effect on net income	Effect on cash	Connection across the three statements
Depreciation	Decrease	No current-period cash outflow	Added back in OCF; PP&E decreases
Increase in receivables	Already reflected in revenue and earnings	Cash not yet collected	Deducted from OCF; assets increase
Increase in inventories	Not immediately expensed in full	Cash used	Deducted from OCF; assets increase
Increase in accounts payable	Expenses or inventory may be recognized	Cash not yet paid	Added in OCF; liabilities increase
Stock-based compensation	Decrease	No direct cash outflow	Added back in OCF; affects equity and share count
Gain on asset disposal	Increase	Sale proceeds received	Disposal gain removed from OCF; sale proceeds included in ICF

3-3. Depreciation is a key link between the three financial statements

Assume a company buys equipment for cash of 500 (KRW 100m).

At the time of the equipment purchase, the following changes occur.

Balance sheet: cash decreases by 500 and PP&E increases by 500 (KRW 100m)
Cash flow statement: investing cash outflow of 500 (KRW 100m)
Income statement: the purchase amount of 500 (KRW 100m) is generally not immediately expensed in full

If the equipment is depreciated on a straight-line basis over 5 years, annual depreciation is simply as follows.

\[ \text{Annual depreciation}=500\div5=100\text{ (KRW 100m)} \]

Each subsequent year, the following changes occur.

Income statement: depreciation expense of 100 (KRW 100m) → lower operating income
Cash flow statement: 100 (KRW 100m) is added back when calculating OCF because it is not a direct cash outflow
Balance sheet: the carrying amount of PP&E decreases by 100 (KRW 100m)

Thus, CapEx uses cash at the time of investment, while depreciation reduces earnings over several subsequent periods.

3-4. Working capital changes connect the balance sheet and OCF

Working capital items appear on the balance sheet, while their changes are reflected in the cash flow statement.

Accounts receivable

\[ \text{Closing receivables}-\text{Opening receivables}>0 \]

An increase in receivables means some recognized revenue has not yet been collected in cash. The increase is therefore deducted from OCF.

Inventories

An increase in inventory means cash spent on production or purchases has not yet fully become cost of sales. The increase is deducted from OCF.

Accounts payable

An increase in payables means the company received materials or services but deferred cash payment. The increase is added to OCF.

The general direction of working capital effects is as follows.

\[ \text{Increase in working capital assets}\rightarrow\text{Lower OCF} \]

\[ \text{Increase in working capital liabilities}\rightarrow\text{Higher OCF} \]

However, some items, such as cash, borrowings and income taxes, are excluded from working capital calculations or treated separately. A definition appropriate to the analysis is therefore needed.

3-5. The connection between CapEx and PP&E

In simplified form, the carrying amount of PP&E changes as follows.

\[ \text{Closing PP\&E} = \text{Opening PP\&E} +\text{New CapEx} -\text{Depreciation} -\text{Carrying amount of assets disposed} \pm\text{Other adjustments} \]

Other adjustments may include the following.

Exchange-rate changes
Business acquisitions and disposals
Impairment losses
Non-cash equipment acquisitions
Transfers from construction in progress to completed asset accounts
Revaluation

If cash flow statement CapEx differs from additions in the PP&E notes, check unpaid equipment purchases, leases, business acquisitions and similar items.

3-6. Borrowings connect the balance sheet and financing cash flow

If a company takes out new borrowing of 300 (KRW 100m), the following changes occur.

Balance sheet: cash increases by 300 and borrowings increase by 300 (KRW 100m)
Cash flow statement: financing cash inflow of 300 (KRW 100m)
Income statement: generally no direct effect when the borrowing occurs

When interest subsequently accrues, the connections are as follows.

Income statement: higher interest expense → lower net income
Cash flow statement: cash flow from interest payments
Balance sheet: cash or interest payable changes

Repaying loan principal is not an expense.

Income statement: principal repayment itself is not expensed
Balance sheet: cash and borrowings decrease together
Cash flow statement: financing cash outflow

3-7. The connection of dividends and share repurchases

Dividends

If a company pays dividends of 50 (KRW 100m), the general effects are as follows.

Income statement: no effect
Balance sheet: cash decreases by 50 and retained earnings decrease by 50 (KRW 100m)
Cash flow statement: financing cash outflow of 50 (KRW 100m)

If dividends have been declared but not yet paid, dividends payable may first be recognized as a liability. Distinguish the declaration date from the payment date.

Share repurchases

If a company repurchases shares for 50 (KRW 100m), the effects are as follows.

Income statement: generally not expensed immediately
Balance sheet: cash decreases by 50 and equity is reduced by 50 (KRW 100m)
Cash flow statement: financing cash outflow of 50 (KRW 100m)

Whether share repurchases increase per-share value depends on the repurchase price, cancellation of shares, reissuance for stock-based compensation and use of borrowing.

3-8. Closing cash is the final reconciliation point

The final cash flow statement balance must match cash on the balance sheet.

\[ \text{Closing cash} = \text{Opening cash} +OCF +ICF +CFF +\text{Foreign-exchange effects and other items} \]

Common reasons why closing cash does not match include the following.

Mixing consolidated and standalone financial statements
Mixing standalone quarterly and cumulative figures
Mixing cash with short-term financial products
Omitting foreign-exchange effects
Omitting cash flows from discontinued operations
Differences in the scope of cash and cash equivalents
Unit errors
Sign errors

3-9. Non-cash transactions may not appear in the main cash flow statement

If a company acquires equipment through a lease or issues shares to acquire another company, assets and liabilities or equity change, but cash may not move immediately.

Typical non-cash transactions include the following.

Equipment acquired through a finance lease
Business acquisitions through a share exchange
Conversion of convertible bonds into shares
Debt-to-equity swaps
PP&E acquired through accounts payable

These transactions may be missed by reading only the main cash flow statement. Check the notes on non-cash transactions, leases and acquisitions.

4. A simple numerical example

The following is a Hypothetical annual example for learning for manufacturing company A. Monetary amounts are in KRW 100 million units.

① Opening balance sheet

Assets	Amount	Liabilities and equity	Amount
Cash	100	Accounts payable	100
Accounts receivable	100	Borrowings	400
Inventories	150	Shareholders' equity	400
Property, plant and equipment	500
Other assets	50
Total assets	900	Total liabilities and equity	900

② Current-period earnings and major transactions

Net income: 100
Depreciation: 50
Increase in receivables: 20
Increase in inventory: 30
Increase in payables: 10
New CapEx: 150
New borrowings: 80
Debt repayment: 20
Dividends paid: 30
Foreign-exchange effects and other adjustments: none

③ Operating cash flow

\[ OCF = 100+50-20-30+10 =110 \]

Item	OCF adjustments
Net income for the period	+100
Depreciation	+50
Increase in receivables	-20
Increase in inventories	-30
Increase in accounts payable	+10
OCF	+110

④ Investing cash flow

\[ ICF=-CapEx=-150 \]

⑤ Financing cash flow

\[ CFF = \text{New borrowings }80 -\text{Principal repayment }20 -\text{Dividends }30 =30 \]

⑥ Change in cash

\[ \text{Net change in cash} = OCF\,110+ICF\,(-150)+CFF\,30 =-10 \]

\[ \text{Closing cash} = \text{Opening cash }100-10 =90 \]

⑦ Calculating the closing balance sheet

Accounts receivable

\[ 100+20=120 \]

Inventories

\[ 150+30=180 \]

Property, plant and equipment

\[ 500+CapEx\,150-\text{Depreciation }50=600 \]

Borrowings

\[ 400+\text{New borrowings }80-\text{Repayment }20=460 \]

Accounts payable

\[ 100+10=110 \]

Shareholders' equity

\[ 400+\text{Net income }100-\text{Dividends }30=470 \]

⑧ Closing balance sheet

Assets	Amount	Liabilities and equity	Amount
Cash	90	Accounts payable	110
Accounts receivable	120	Borrowings	460
Inventories	180	Shareholders' equity	470
Property, plant and equipment	600
Other assets	50
Total assets	1,040	Total liabilities and equity	1,040

Finally, both of the following equations reconcile.

\[ \text{Assets }1,040=\text{Liabilities }570+\text{Equity }470 \]

\[ \text{Closing cash }90=\text{Opening cash }100+\text{Net change in cash }(-10) \]

⑨ FCF

\[ FCF=OCF110-CapEx150=-40 \]

Net income is 100 (KRW 100m), but growth investment and increased working capital produce an FCF deficit of 40 (KRW 100m). New borrowing finances part of the cash shortfall.

5. Practical use in stock and company analysis

① Start with the income statement and verify with cash

Check in the following order.

\[ \text{Revenue} \rightarrow\text{Operating income} \rightarrow\text{Net income} \rightarrow OCF \rightarrow FCF \]

Did earnings rise while OCF fell?
Did OCF growth depend on working capital recovery?
Did growth CapEx cause the FCF decline?
Is borrowing financing the FCF shortfall?

② Examine the cost of revenue growth

Even if revenue grows quickly, cash efficiency can deteriorate if the following items grow faster.

Accounts receivable
Inventories
Contract acquisition costs
Property, plant and equipment
Borrowings

For example, if revenue rose 10% but receivables and inventory each rose 40%, the quality of growth should be questioned.

③ Examine what increased borrowing funds

The use of borrowing matters more than the increase itself.

Use of borrowings	Initial assessment
Growth investment with high returns	May increase future value
Temporary working capital shortfall	Check whether the cash will be recovered
Recurring operating losses	Warning sign
Dividends and share repurchases	Check FCF coverage and financial capacity
Refinancing existing debt	Check interest rates and maturity structure
Business acquisitions	Check acquisition profitability and goodwill

④ A financial model must balance

The three financial statements must also be connected when forecasting company results.

Estimate revenue and expenses to calculate net income
Calculate OCF from net income and working capital
Estimate PP&E and depreciation using CapEx
Estimate borrowing and repayment based on cash shortfalls or surpluses
Feed interest expense back into the income statement
Calculate final cash and shareholders' equity
Assets = Liabilities + Equity Check

If cash is insufficient but the model assumes no borrowing or equity issuance, it is not realistic.

⑤ FCF exceeding net income is not always a good sign

OCF can be temporarily inflated in the following ways.

Sharp inventory reduction
Temporary collection of receivables
Delayed payment of accounts payable
Sharp increase in customer advances
Deferral of tax payments

Conversely, normal increases in inventory and receivables to fulfill large customer contracts may weaken short-term OCF. Separate the causes.

⑥ Examine warning signs across all three financial statements together

Warning sign	Possible cause
Net income ↑, OCF ↓, receivables ↑	Deteriorating collections or aggressive revenue recognition
Flat revenue, inventory ↑, borrowings ↑	Slowing demand or overproduction
CapEx ↑, borrowings ↑, depreciation ↑	Investment expansion and future fixed-cost burden
OCF ↑, payables ↑	Possible temporary improvement from delayed supplier payments
Net income ↑, cash ↓	Possible CapEx, acquisitions, dividends or debt repayments
Share repurchases ↑, total shares unchanged	May merely offset dilution from stock-based compensation

6. What to look for in disclosures

Korean companies: DART

Financial Supervisory Service DART: check in the following order.

Disclosure document or item	Check connections across the three statements
Consolidated statement of comprehensive income	Net income and depreciation-related expenses
Consolidated balance sheet	Opening and closing balances of assets, liabilities and equity
Consolidated cash flow statement	OCF, ICF, CFF and changes in cash
Consolidated statement of changes in equity	Net income, dividends, treasury shares and changes in equity
Cash notes	Whether the amount matches closing cash on the cash flow statement
Notes on receivables, inventory and payables	Reasons for working capital changes
Property, plant and equipment notes	Acquisitions, depreciation, disposals and impairments
Borrowings and bonds notes	New borrowing, repayments and reclassification to current liabilities
Dividend and treasury share notes	Reductions in retained earnings and equity
Non-cash transactions note	Leases, share exchanges and unpaid equipment purchases

In actual analysis, always align the following bases.

Consolidated versus standalone
Opening and closing consolidation scope
Standalone quarter versus cumulative period
Units such as KRW, KRW thousands or KRW millions
Continuing and discontinued operations
Definition of cash and cash equivalents

US companies: 10-K and 10-Q

SEC EDGAR: connect and review the following statements and notes.

Consolidated Statements of Operations
Consolidated Balance Sheets
Consolidated Statements of Cash Flows
Consolidated Statements of Stockholders’ Equity
Property, plant and equipment
Debt
Stock-based compensation
Share repurchases
Commitments and contingencies
Supplemental cash flow disclosures

In a 10-K, financial statements are mainly in Item 8. Financial Statements and Supplementary Data; in a 10-Q, in Part I, Item 1. Financial Statements.

When reconciling adjusted results in company earnings materials with SEC filings, distinguish the following.

GAAP or IFRS disclosed figures
Company-adjusted non-GAAP figures
Values calculated directly from disclosed figures
Analyst estimates

7. Key takeaways

Net income is both the starting point for OCF on the cash flow statement and an increase in retained earnings on the balance sheet.
Depreciation reduces earnings and PP&E, but is added back to OCF because it is not a current-period cash outflow.
Increases in receivables and inventory generally reduce OCF, while increases in payables increase OCF.
CapEx creates an investing cash outflow and increases PP&E, which subsequently generates depreciation expense.
New borrowing and repayment are reflected in financing cash flow and balance-sheet borrowings.
Dividends distribute profits rather than creating an expense, so they reduce cash and retained earnings.
The cash flow statement's net change in cash must reconcile opening and closing cash on the balance sheet.
Non-cash transactions such as leases, share exchanges and unpaid equipment purchases are difficult to identify from the main cash flow statement alone.
Company analysis and financial models must ultimately reconcile Assets = Liabilities + Equity.

8. Three review questions

Question 1

If opening retained earnings are 500, net income is 120 and dividends are 40 (all amounts in KRW 100m), what are closing retained earnings with no other adjustments?

Question 2

If opening PP&E is 800, new CapEx is 250 and depreciation is 100 (all amounts in KRW 100m), what is closing PP&E with no disposals, impairments or foreign-exchange effects?

Question 3

If opening cash is 200, OCF is 300, investing cash flow is -420 and financing cash flow is +80 (all amounts in KRW 100m), what is closing cash? Assume no foreign-exchange effects.

Answers and explanations

Answer 1

\[ \text{Closing retained earnings} =500+120-40 =580\text{ (KRW 100m)} \]

Net income increases retained earnings, while dividends reduce them.

Answer 2

\[ \text{Closing PP\&E} =800+250-100 =950\text{ (KRW 100m)} \]

CapEx increases PP&E, while depreciation reduces its carrying amount.

Answer 3

\[ \text{Net change in cash} =300-420+80 =-40\text{ (KRW 100m)} \]

\[ \text{Closing cash} =200-40 =160\text{ (KRW 100m)} \]

Operations generated 300 (KRW 100m), but investment spending was larger, and financing activities funded part of the shortfall.

Next lesson — Day 8:
“How Much Does a Good Company Earn on Its Investment? — The Concept and Calculation of ROIC”