RISK ANALYSIS managing its investments

sustainably.
INTRODUCTION TO RISK ANALYSIS
 Financing Activities:
Risk Analysis
o This includes transactions with
 A structured method of examining
lenders and investors, such as
financial statements to detect, assess,
issuing stocks or borrowing
and manage financial threats that may
money.
affect a company’s performance and
survival. o Cash is used for repaying debts
and paying dividends.
B. Purpose and Significance
o The associated risk is also Long-
 The purpose is to evaluate a company's
Term Solvency Risk, as it
profitability, growth, and risk exposure
measures the company's ability
helping businesses prepare for and
to service debt and maintain
adapt to uncertainties.
investor confidence over time.
C. Framework for Cash Flow Activities
 Operating Activities:
SOURCES OF RISK
o These generate cash from the
A. Firm-Specific Risk
company’s core income-
generating functions such as Risks unique to a single company, often from
selling goods or services. internal factors.
o Cash is used for working capital  Management Competence:
requirements like payroll, taxes, Leadership's effectiveness in decision-
and inventory. making.
o The main risk analyzed is Short-  Strategic Direction: Company's long-
Term Liquidity Risk, which looks term goals and plans.
at whether the company can
meet its short-term financial  Lawsuits: Legal claims that may affect
obligations. finances or reputation.

 Investing Activities: B. Industry Risk

o These involve buying or selling Risks that impact all businesses in the same
sector.
long-term assets like
equipment, land, or  Technology Shifts: Innovations that may
investments. render products obsolete.
o The cash generated from selling  Competition: Rivalry that reduces
assets is used for plant market share or profits.
expansion or acquiring new
assets.  Raw material and Labor Shortages:
Supply chain disruptions or labor
o The related risk is Long-Term shortages can halt production and
Solvency Risk, focusing on increase costs.
whether the company is

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  Unionization: Workforce issues o Profit Margin = Net Income /
affecting operations. Unionized Sales
workforces can lead to higher labor
costs or operational disruptions due to o Asset Turnover = Sales /
strikes. Average Assets

C. Domestic Risk o Capital Structure Leverage =

Avg. Assets / Avg. Equity
Country-specific economic or political risks.
 Interest Payments: The company must
 Recession: Period of economic decline. pay interest regardless of its
performance.
 Inflation/Deflation: Rising or falling
prices that impact costs.  Repayment Risk: If the company’s
investments don’t perform as expected,
 Interest Rates: Affect borrowing costs
it may struggle to repay debt.
and investment returns.
 Greater Risk with Higher Leverage: As
 Demographic & Political Changes: Shifts
leverage increases, so does the
in population or government that
potential for financial distress.
impact business.
B. Short-Term Liquidity Risk
D. International Risk
Risk of not covering near-term liabilities. The
Global or foreign-market risks.
ability to generate sufficient cash to supply
 Currency Exchange Rate Changes: Value operating working capital needs to service
fluctuations in foreign currencies. debts. Arises from: unlimited cash inflows and
outflows, high degree of long-term leverage.
 Government Regulations: Rules
affecting trade or investment.  Current Ratio: Ability to pay short-term
debt with current assets.
 Political Unrest: Instability disrupting
operations. o Current Ratio = Current assets /
current liabilities
 Expropriation of Assets: Government
seizure of private assets. o Ratio > 1 = good Ratio < 1 =
risky
 Quick Ratio: More conservative than
TYPES OF RISK current ratio (excludes inventory).
A. Financial Flexibility o Quick Ratio = Current assets –
A firm's adaptability in raising funds or inventory and prepaid
reallocating resources. expense / current liabilities

 Financial Leverage: Use of debt to boost o Ratio > 1 = good Ratio < 1 =
returns. risky

 ROCE (Return on Capital Employed):  Operating Cash Flow to Current

Profitability relative to capital used. Liabilities: Cash from core operations vs
(Profit Margin × Asset Turnover × obligations.
Capital Structure Leverage)

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 o Operating Cash Flow to Current o Long-Term Debt to
Liabilities = Cash Flow from Shareholders’ Equity = Long-
Operations / Current liabilities Term Debt / Total Equity
 Interpretation of Debt Ratio:
 Working Capital Turnover: Sales o ≤ 0.40 – Low risk: company
efficiency with working capital.
relies more on equity
o Working Capital Turnover = Net o 0.41 to 0.59 – Moderate risk:
sales / Working capital balanced debt-equity mix
o ≥ 0.60 – High risk: heavy
 Accounts Receivable Turnover: How dependence on borrowed funds
often receivables are collected. o A higher debt ratio means
o Accounts Receivable Turnover greater financial leverage but
= Net credit sales / average also greater financial risk,
accounts receivable especially if cash flows are
insufficient to cover fixed
 Inventory Turnover: Rate of selling and obligations.
replacing inventory.  Interest Coverage Ratio: Times earnings
cover interest payments.
o Inventory turnover = Cost of
goods sold / average
o Interest Coverage Ratio =
inventories
EBIT / Interest Expense
 Accounts Payable Turnover: Speed of  Interpretation of ICR:
paying suppliers. o < 1.0 – Very high risk: not
enough earnings to pay interest
o APT = supplier purchases / o 1.0 to 1.5 – High risk: barely
average accounts payable meeting interest payments
 Cash Turnover Ratio: Times cash is used o 1.5 to 2.5 – Moderate risk:
and replenished annually. limited cushion for downturns
o 2.5 to 3.5 – Low risk:
o Revenue / Average cash and comfortably meeting interest
cash equivalents payments
o > 3.5 – Very low risk: strong
C. Long-Term Solvency Risk
financial position
Risk of not meeting long-term financial  Operating Cash Flow to Total Liabilities:
commitments. Indicates how well debt is covered by
operations.
 Debt Ratio: Proportion of assets
financed by liabilities. o Operating Cash Flow to Total
Liabilities = Operating Cash
o Debt Ratio = Total Liabilities /
Flow / Total Liabilities
Total Assets
o A higher ratio indicates better
o Liabilities to Shareholders’ financial health, as the company
Equity = Total Liabilities / Total generates more cash to service
Equity its obligations. A low ratio
o Long-Term Debt to Long-Term signals potential liquidity
Capital = Long-Term Debt / problems.
(Long-Term Debt + Equity)

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D. Credit Risk  Altman Z-Score: Combines several
metrics to predict insolvency.
Risk that a borrower won’t fulfill repayment
terms.
o Z = 1.2 × (Working Capital /
 Loan Purpose: Reason for borrowing Total Assets) + 1.4 × (Retained
affects risk level. Earnings / Total Assets) + 3.3 ×
(EBIT / Total Assets) + 0.6 ×
 Credit History: Record of past (Market Value of Equity / Total
borrowing and repayment. Liabilities) + 1.0 × (Sales / Total
 Cash Flows: Indicates ability to generate Assets)
funds for repayments. o Z > 3.0 = Low bankruptcy risk
o Z < 1.81 = High bankruptcy risk
 Collateral: Assets pledged as loan o Z between 1.81 and 3.0 =
security. Uncertain or "gray" area
 Logit Analysis: Uses statistical
E. Bankruptcy Risk
regression on variables like liquidity,
Likelihood of becoming unable to pay debts. debt, and profitability to predict
bankruptcy.
 Univariate Analysis: Examines single
financial ratios to assess bankruptcy. o P = 1 / (1 + e^-(α + β₁X₁ + β₂X₂
+ ... + βnXn)) Where:
o Common indicators: Net Income
/ Assets, Debt / Assets, Working o P = probability of bankruptcy
Capital / Assets, etc. o e = Euler’s number (approx.
2.718)
o Net Income plus Depreciation, o α = intercept
Depletion, and o β = coefficients
Amortization/Total Liabilities
o X = financial predictors (e.g.,
(long-term solvency risk)
liquidity, leverage, profitability)
o Net Income/Total Assets o The result is a probability score
(profitability) (0–1) indicating the likelihood
of default. A score closer to 1
o Total Debt/Total Assets (long- suggests high risk of
term solvency risk) bankruptcy.
o Net Working Capital/Total
Assets (short-term liquidity risk) F. Systematic Risk

o Current Assets/Current Broad risks affecting the entire market.

Liabilities (short-term liquidity  Beta Coefficient (β): Measures a stock’s
risk) volatility relative to the market.
o Cash, Marketable Securities, o β = 1: Market average
Accounts Receivable/Operating
Expenses Excluding o β > 1: More volatile
Depreciation, Depletion, and
o β < 1: Less volatile
Amortization (short-term
liquidity risk)

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  Volatility Score:  Outflows / Cash Payment: Payments for
goods, wages, taxes, other expenses
o High Risk = High returns
B. Investing Activities
o Low Risks = Low returns
Acquisition or disposal of long-term assets.
 Degree of Operating Leverage (DOL):
Fixed costs' impact on operating  Inflows: Sale of investments,
income. equipment, or loan collections
o Degree of Operating Leverage  Outflows: Purchases of equipment or
(DOL) = Contribution Margin / long-term securities
Operating Income
C. Financing Activities
 Degree of Financial Leverage (DFL):
Raising capital or repaying investors.
Debt's impact on income variability.
 Inflows: Loan proceeds, equity issuance
o Degree of Financial Leverage
(DFL) = EBIT / (EBIT - Interest  Outflows: Repaying debt, dividends,
Expense) repurchasing stock
 Sales Variance: Difference between
actual and expected sales.
o Volume Variance: Units sold vs
planned
 (Actual Volume –
Budgeted Volume) ×
Budgeted Price
o Price Variance: Selling price vs
planned price
 (Actual Price –
Budgeted Price) ×
Actual Volume
o Value Variance: Total actual vs
budgeted revenue
 Actual Revenue –
Budgeted Revenue

CASH FLOW ACTIVITIES

A. Operating Activities
Daily transactions related to revenue generation
/ net income.
 Inflows / Cash Receipt: Sales, interest,
dividends received

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OVERVIEW OF FINANCIAL REPORTING, 2. Threat of New Entrants: Indicates how
FINANCIAL STATEMENT ANALYSIS AND easily new competitors can enter the
VALUATION market.
 Low barriers to entry: If it's
Six-Step Analytical Process relatively easy for new firms to
This framework is used to analyze a firm's enter a market, the threat of
financial performance and value by new entrants is high.
understanding its industry, strategies, and  High barriers to entry: If there
financial data. are significant barriers to entry,
the threat of new entrants is
1. Identify Industry Economic lower. These barriers can
Characteristics include:
2. Identify Company Strategies o Economies of scale:
3. Assess Quality of Financial Statements Existing firms may have
4. Analyze Profitability and Risk lower costs per unit due
5. Prepare Forecasted Financial to large-scale
Statements production.
6. Value the Firm o Network effects: The
STEP 1: Identify Industry Economic value of a product or
Characteristics service may increase as
more customers use it.
Understanding the economic traits of the o Government
industry helps assess how a firm operates. regulations: Licensing
requirements, tariffs, or
 Economic factors and competition
quotas can make it
influence how businesses operate
difficult for new firms to
 Analysts should consider economic
enter.
factors and competition when analyzing
o Brand loyalty:
financial statements
Established brands may
Porter's Five Forces: have strong customer
loyalty, making it
1. Rivalry Among Existing Firms: difficult for new
Measures competition. entrants to compete.
 Concentrated Rivalry: Intense 3. Threat of Substitutes: Considers
competition among a few alternative products.
dominant firms.  Product differentiation: If
o few large competitors,
products are highly
high entry barriers, and
differentiated, customers may
fierce battles for market
share. be less likely to switch.
 Switching costs: If there are
 Diffuse Rivalry: Competition significant costs associated with
spread among numerous firms. switching, customers may be
o Many small to medium- less willing to do so.
sized competitors, 4. Buyer Power: Assesses the influence of
lower entry barriers, customers on pricing.
and varied strategies.

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  Buyers have the power to o Manufacturing – refers to the
influence price and the quantity processing of raw materials or
of products sold. parts into finished goods
5. Supplier Power: Measures how much through the use of tools, human
influence suppliers have. labor, machinery and chemical
 Suppliers have the power to
processing.
influence price, as well as the
 Capital-intensive:
availability of resources/inputs.
Requires significant
 Value Chain Analysis: Analyzes how investment in
value is created through stages: supply, machinery and
manufacturing, marketing, distribution, equipment.
and customer service.  Labor-intensive: Relies
 Economic Attributes Framework: heavily on human labor.
Focuses on demand, supply,  Complexity: Complex
manufacturing processes, marketing processes have low
tactics, and financial aspects like tolerance for error,
investing and financing. while simpler processes
o Demand - is the consumers allow for some
desire and ability to purchase a variation.
good or service.  Product range: A wide
o Supply - Is the total amount of a range of products may
given product or service a require more flexibility
supplier offers to consumers at and customization.
a given period and a given o Marketing - science of markets
period level. including products, pricing,
 Product uniqueness: If promotion and place.
suppliers offer unique  Business-to-business
products or services (B2B): Products are
that are essential to promoted to other
buyers, they have more businesses.
bargaining power.  Business-to-consumer
 Barriers to entry: If (B2C): Products are
there are high barriers marketed directly to
to entry for new consumers.
suppliers, existing  Demand pull: Steady
suppliers have more demand pulls products
power. through distribution
 Barriers to exit: If there channels.
are high costs  Demand creation:
associated with exiting Firms must actively
the industry, suppliers promote products to
may be less willing to create demand.
negotiate on price.

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 o Investing – includes cash 1. Horizontal Competition: Rivalry among
activities related to non-current existing firms in the same industry.
asset  Factors: Number of
o Financing – include activities competitors, market growth,
related noncurrent liabilities product differentiation, barriers
to entry.
and owner’s equity.
 Impact: Influences price wars,
o Economic Cycle- Expansion,
marketing expenses, and overall
Peak, Recession, Though, industry dynamics.
Expansion. 2. Vertical Competition:
o Customer price sensitivity: How  Buyer Power: Influence
much customers change their customers have on prices and
consumption when prices terms.
change.  Supplier Power: Influence
o Industry growth rate: How fast suppliers have on input prices
the industry is expanding. and terms.
o Demand sensitivity to the  Impact: Affects industry
economic cycle: How much profitability; high power may
demand is affected by economic lead to unfavorable conditions
fluctuations. for firms.
o Seasonality of demand: How
much demand varies
throughout the year. STEP 2: Identify Company Strategies
o
A company’s business model and competitive
Formulas: approach are critical to understanding financial
performance.
1. Profit Margin- indicates how many
cents of profit the business has Product Strategies
generated for each of sale. 1. Product Differentiation: Offers unique
 Formula : Sales- Cost/ Net Sales products with higher profit margins.
2. Asset Turn Over- measures the value of 2. Low-Cost Leadership: Provides
a company’s revenue relative to the standardized goods with lower prices,
value of its asset. aiming for larger market share.
 Formula: Total Sales / (Beg.
Assets+ Ending Assets/2) Integration in the Value Chain:
3. Return on Asset- Gives investors an idea
1. Manufacturing: The company may
of how effective the company is in
produce everything, outsource, or do a
converting money it invests into net
mix (e.g., in-house assembly).
income.
2. Distribution: May be controlled
 Formula: Net Income / Total
internally or outsourced.
Assets
4. Long Term Debt to Total Asset Ratio-
indicates the percentage of assets that
are being financed with debt. The
higher the ratio, the greater the risk
 Formula: Short Term Debt +
Long Term Debt / Total Assets

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Geographic scope:  Understand the principles used in
preparing statements.
1. Domestic market: Firms can focus on  Balance Sheet (Statement of Financial
their domestic market. Position):
2. Horizontal integration: Firms can o Formula: Assets = Liabilities +
expand across multiple countries to Shareholders' Equity.
achieve economies of scale and access o Assets must have future
new markets. economic benefits and
measurable value.
Diversification strategy
 Types: Current Assets,
1. Single industry: Firms can focus on a Investments, Property,
single industry. Intangibles.
2. Diversification: Firms can expand into o Liabilities represent expected
sacrifices to settle obligations.
multiple industries to reduce risk or
 Types: Current (due in 1
capitalize on new opportunities.
year), Noncurrent (long-
STEP 3: Assess the Quality of Financial term debts, deferred
Statements taxes).

Evaluate the reliability and usefulness of a firm's  Balance Sheet Limitations:

financial reports. o Assets not acquired from others
 Assets - are resources a business either or not measurable may be
owns or controls that are expected to missing.
result in future economic value. o Nonmonetary assets are shown
 Current Assets - Cash, Cash Equivalents, at cost minus depreciation.
Stock or Inventory, Accounts Receivable, o Liabilities appear at present
Marketable Securities and Prepaid value of expected cash flows.
Expense.
 Investments - Stocks, Bonds, Fixed  Income Statement (Operating
Deposit, etc. Performance):
 PPE - Building, Machinery, Land, Office o Shows profitability over a
Equipment, Furniture and Vehicles period.
 Liabilities - are obligations a company o Under accrual accounting,
has to pay in the future. revenue is recorded when
 Shareholders' equity represents the earned, not when cash is
residual interest or claim of received.
shareholders in a firm. It includes: o Profitability: Shows a
 Contributed capital: Amounts initially company's profitability over a
invested by shareholders. period.
 Retained earnings: Cumulative net o Accrual basis: Revenue
income minus dividends. recognized when earned, not
 Other comprehensive income: Gains or just when paid.
losses not included in net income. o Revenue recognition: Revenue
is recognized when the
company has completed its

Accounting Quality:

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 obligation and has a reasonable Financial Analysis Tools
certainty of receiving payment.
Common-size financial statements: These
 Statement of Cash Flows:
statements express all items as a percentage of
o Shows cash generation and
a specific base item (e.g., total assets for the
usage in Operating, Investing, balance sheet, total revenue for the income
and Financing activities. statement). This allows for easier comparison
o Non-cash activities appear in across different companies or time periods.
notes or supplementary
schedules. Percentage change financial statements: These
o Free cash flows: Assesses a statements show the percentage change in each
company's ability to generate item from one period to another. This helps
cash. identify trends and changes in a company's
o Categories: Operating, financial performance.
investing, and financing Financial statement ratios: These are
activities. calculations that help analyze a company's
o Non-cash transactions: financial performance and risk. They are often
Disclosed in a schedule or note. categorized into:
o Operating Activities - Provides • Profitability ratios: Measure a
information on cash generated company's ability to generate profits.
and used by a firm in its normal
activities of selling goods and • Earnings per share (EPS): Net
providing services. income divided by the number
of outstanding shares.
o Investing Activities- Provides
information about the firm’s use • Return on capital employed
of cash in the acquisition of long (ROCE): Net profit before
lived productive assets and cash interest and taxes divided by
provided by the disposal of long total capital employed.
lived productive assets. • Risk ratios: Measure a company's
o Financing Activities- Provides financial risk.
information about cash
provided and used by short- and • Current ratio: Current assets
long term borrowing and from divided by current liabilities.
issuing or repurchasing capital • Debt to equity ratio: Total debt
stock. divided by total equity.
 GAAP – Generally Accepted Accounting
Principle STEP 5: Prepare Forecasted Financial
 SEC- Securities and Exchange Statements
Commission Project future income, expenses, assets,
 FASB- Financial Accounting Standards liabilities, and cash flows using past trends and
Board current strategies.
STEP 4: Analyze Profitability and Risk Forecasts are crucial for financial analysis and
Determine how well the company is performing valuation. They provide the input data for
and the financial risks it faces. valuation models, and the accuracy of these
forecasts directly impacts the reliability of the
valuation.

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Forecasted financial statements are based on Sources of Financial Statement Information
assumptions made by the analyst about future
events. These assumptions include factors like 1. Financial Statements (Balance Sheet,
economic conditions, industry trends, company- Income Statement, etc.)
specific developments, and management 2. Footnotes
decisions. 3. Management’s Discussion and Analysis
4. Auditor’s Reports

STEP 6: Value the Firm

Estimate the company’s worth using these
approaches:
1. Dividend-based: Values based on future
dividends.
2. Earnings-based: Values based on future
earnings (P/E ratio).
3. Cash flow-based: Values based on
future cash flows (DCF).
4. Market-based: Values based on similar
companies.

Note: The first three typically produce

similar results.

Role of Financial Statement Analysis in Efficient

Markets
In efficient markets, stock prices quickly reflect
all publicly available information.

Implication:
 It becomes harder to find undervalued
or overvalued stocks because new data
is already factored into prices.
Benefits of efficient capital markets:
• Rapid price adjustment: Stock prices
quickly reflect new information.
• Reduced mispricing: It's harder to find
undervalued or overvalued stocks.
Association Between Earnings and Share Prices
There is a strong correlation. As earnings go up,
share prices generally rise, and vice versa.

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MODULE 2: ASSET AND LIABILITY VALUATION  Provide insight on timing and risk of
AND INCOME RECOGNITION future cash flows.
 Help users make informed economic
Mixed Attribute Accounting Model decisions.
 Used in financial reporting to balance Historical Value
relevance and reliability of information.
It helps users understand the risk, 1. Acquisition Cost: Price paid to acquire
timing, and amount of future cash an asset, including necessary costs to
flows. prepare for use (e.g., shipping,
installation). Operating costs are
Assets are divided into: excluded.
 Current Assets: Converted to cash or 2. Adjusted Historical Cost: Value
used within a year or operating cycle decreases over time as the asset is
(e.g., Cash, Receivables, Inventory, used. Depreciation or amortization
Prepaid expenses) spreads cost over useful life (applies to
 Non-current Assets: Provide benefits buildings, machinery, intangibles).
beyond one year (e.g., PP&E, 3. Present Value: Used for monetary
Intangibles like patents, Long-term assets/liabilities. Calculates value using
investments, Deferred tax assets). discounted future cash flows with
appropriate interest rates (e.g., bonds,
long-term receivables/payables).
Liabilities are divided into:
 Current Liabilities: Settled within one Current Values – Fair Value
year (e.g., Accounts payable, Short-term
borrowings, Accrued expenses).  Fair Value: Market-based valuation.
 Non-current Liabilities: Obligations Defined as:
beyond one year (e.g., Long-term debt, o FASB: Exit Price (what you'd get
Deferred taxes, Lease obligations). selling the asset).
o IASB: Either Exit or Entry Price
(entry = purchase price).
Asset and Liability Valuation
Valuation methods ensure relevant and reliable Fair Value Hierarchy (from SFAS No.157 and
information in financial reports. IFRS No.7):
Relevance in financial statements ensures that 1. Level 1: Market prices from active
the information provided is timely, predictive, markets (most reliable).
confirmatory, material, complete, comparable, 2. Level 2: Observable inputs (quoted
and understandable, enabling users to make prices for similar items).
informed economic decisions. 3. Level 3: Unobservable inputs
Reliability in financial statements refers to the (management estimates).
quality of the information presented, ensuring it Examples: Equity/debt securities, derivatives,
is accurate, faithful, and free from bias or some financial instruments.
material error, thus fostering trust among users
in making economic decisions.

Goals: Income Recognition

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  Revenue is recognized when it is earned carrying amount of liability exceeds its
and realizable. tax base.
Example:
 Income or Expense items
Approach 2 (Hybrid): Combines traditional
that are not allowed by tax
historical cost and fair value approaches.
Balances relevance with stability. Used under US legislation.
GAAP and IFRS.  Tax credits for some
expenditures directly
 Goal: Show timely and fair performance reduces taxes.
on income statements while avoiding
wild swings in reported income. Deferred tax assets and liabilities reflect
expected future tax effects.

Income Taxes
Companies report income tax expenses based Measuring Income Tax Expense
on both current and deferred taxes.
Includes:
 Permanent Differences: Do not reverse
1. Current Tax Expense: Based on taxable
over time (e.g., fines, non-deductible
income.
expenses).
2. Deferred Tax Expense: Based on
 Temporary Differences: Timing
changes in deferred tax
differences between book income and
assets/liabilities.
taxable income that reverse in future
periods. Total income tax expense = Current + Deferred
1. Deferred Tax Asset = Reported Income
Tax - Income Tax Payable
Types:
2. Deferred Tax Liability = Income Tax
1. Taxable Temporary Difference - are Payable - Reported Income Tax
temporary differences that result in a
taxable amount in future when
Discontinued Operations and Extraordinary
determining the taxable profit as the
Items
relevant balance sheet item is recovered
or settled. Special reporting required for parts of a
business that are discontinued or unusual one-
2. Taxable Temporary Differences result in
time events.
a deferred tax liability when the
carrying amount of an asset exceeds its 1. Discontinued Operations: Reported
tax base, or when the tax base of separately from continuing operations
liability exceeds its carrying amount. to show impact clearly.
2. Extraordinary Items: Rare and unusual
3. Deductible Temporary Difference -
events (Note: This category is no longer
results in a reduction or deduction of
used under current GAAP but may still
taxable income in future when the
appear historically).
relevant balance sheet item is recovered
or settled. They result in a deferred tax
asset when the tax base of an asset Other Comprehensive Income (OCI)
exceeds its carrying amount, or the

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Items included in OCI do not affect net income MODULE 3: INCOME FLOWS VERSUS CASH
directly but impact shareholders' equity. FLOWS
Examples (net of tax): Income Statement: Measures profitability using
revenues and expenses over a period. Follows
 Unrealized gains/losses on marketable accrual accounting.
securities
 Gains/losses on hedged financial Statement of Cash Flows: Tracks actual cash
instruments and derivatives inflows and outflows categorized into:
 Foreign currency translation
adjustments 1. Operating activities
 Pension liability adjustments 2. Investing activities
3. Financing activities
Analytical Framework Why Income ≠ Cash Flow?
Core Accounting Equation: Assets = Liabilities +  Income follows accrual accounting
Shareholders’ Equity (recognizes revenue and expenses when
incurred, not when cash is exchanged).
Shareholders' Equity includes:  Includes noncash items (e.g.,
 Contributed Capital (CC): Money from depreciation, amortization).
issuing shares.  Cash flows reflect only actual
 Retained Earnings (RE): Net income not movement of money.
paid as dividends. Statement of Cash Flows (IAS 7 and US GAAP)
 Accumulated Other Comprehensive
Income (AOCI): Unrealized gains/losses  Cash equivalents include treasury bills,
not included in net income. commercial paper, money market funds,
and under IAS 7, bank overdrafts.
Total Shareholder’s equity = CC + AOCI + RE  Reporting Differences:
Used to analyze a company’s financial health o Interest Paid: Operating or
and understand changes in financial position. Financing
o Interest Received and
Dividends Received: Operating
or Investing
o Dividends Paid: Financing

Cash Flow Activities

1. Operating: Related to business
operations (sales, salaries, expenses).
2. Investing: Buying or selling long-term
assets (property, investments).
3. Financing: Borrowing, issuing stock, or
paying dividends.
Formula:
Ending Cash = Beginning Cash + Cash
Inflows - Cash Outflows

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Product Life Cycle and Cash Flows  Changes in long-term debt/equity →
Financing activities
1. Introduction
 Low revenue, negative income Exceptions:
 Negative cash flow from  Marketable securities → Investing
operations and investing  Notes payable to banks → Financing
 Positive cash flow from  portion of long-term debt → Financing
financing (external funds)
2. Growth Usefulness of the Statement of Cash Flows
 Growing income and operating
cash flow  Helps assess whether net income
 Continued investing, reduced reflects actual business economics.
external financing  Highlights accounting accruals.
3. Maturity  Evaluates quality and sustainability of
 Peak performance earnings.
 Positive operations cash flow
 Decreased investing, possible
debt repayment
4. Decline
 Falling revenue and income
 Positive investing (selling assets)
 Negative financing
(repayments)

Cash Flow from Operations

Two methods:
1. Direct Method: Lists cash inflows and
outflows directly.
2. Indirect Method: Adjusts net income
for:
 Non-working capital accounts
(e.g., depreciation, deferred
taxes)
 Working capital changes (e.g.,
A/R, inventory, A/P)

Preparing the Statement of Cash Flows

Accounting Equation:
ΔCash = ΔLiabilities + ΔEquity - ΔNon-Cash
Assets
 Changes in current assets/liabilities →
Operating activities QUESTIONS:
 Changes in fixed/noncurrent assets →
Investing activities MULTIPLE CHOICE QUESTIONS (1–60)

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1. Which activity involves the generation 8. Operating cash flow to total liabilities is
of cash through the core operations of a an indicator of:
company? a) Profitability
a) Investing b) Financial health and solvency
b) Financing c) Market valuation
c) Operating d) Bankruptcy probability
d) Lending
9. What is the most conservative liquidity
2. What risk is primarily assessed when ratio?
analyzing investing activities? a) Current ratio
a) Bankruptcy Risk b) Debt ratio
b) Long-Term Solvency Risk c) Interest coverage
c) Credit Risk d) Quick ratio
d) Short-Term Liquidity Risk
10. Which component is NOT part of the
3. The current ratio is a measure of a Altman Z-score?
company’s: a) EBIT / Total Assets
a) Profitability b) Sales / Total Assets
b) Efficiency c) Working Capital / Total Assets
c) Short-term liquidity d) Quick Ratio
d) Leverage
11. Which of the following best describes
4. A high Debt Ratio (≥ 0.60) indicates: the purpose of risk analysis in financial
a) Strong equity position accounting?
b) Heavy dependence on borrowed a) To set product prices
funds b) To minimize taxes
c) Low solvency risk c) To evaluate profitability, growth, and
d) Low leverage risk exposure
d) To audit financial statements
5. Which of the following represents firm-
specific risk? 12. Which financial ratio is considered most
a) Recession conservative for measuring liquidity?
b) Currency exchange fluctuation a) Debt ratio
c) Management competence b) Quick ratio
d) Raw material shortages c) Current ratio
d) Working capital turnover
6. Which ratio measures how often a
company collects its receivables? 13. What is indicated by a high inventory
a) Inventory Turnover turnover ratio?
b) Cash Turnover a) Excess inventory
c) Accounts Receivable Turnover b) Slow-moving goods
d) Working Capital Turnover c) Efficient inventory management
d) Inability to sell goods
7. What does the quick ratio exclude from
current assets? 14. Which risk is most related to changes in
a) Prepaid expenses only interest rates and inflation?
b) Inventory only a) Firm-specific risk
c) Inventory and prepaid expenses b) International risk
d) Marketable securities c) Industry risk
d) Domestic risk

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15. A beta coefficient greater than 1 22. The primary focus of vertical
indicates: competition analysis is:
a) Lower risk than the market a) Industry growth
b) Higher volatility than the market b) Firm size
c) No volatility c) Power of suppliers and buyers
d) Negative cash flows d) Product prices
16. What does the interest coverage ratio 23. The debt ratio is calculated as:
measure? a) Total equity / Total assets
a) The firm’s dividend-paying ability b) Total liabilities / Total assets
b) The ability to pay interest from c) Total equity / Total liabilities
earnings d) Net income / Total liabilities
c) Operating efficiency
d) Asset turnover 24. What ratio would best indicate how fast
a company pays its suppliers?
17. The formula for working capital a) Inventory turnover
turnover is: b) Receivables turnover
a) Net sales / Total assets c) Accounts payable turnover
b) Net sales / Inventory d) Working capital turnover
c) Net sales / Working capital
d) Working capital / Total liabilities 25. Which stage of the product life cycle is
characterized by high external financing
18. Which of the following is a Level 1 fair and negative operating cash flow?
value input? a) Growth
a) Management estimate b) Maturity
b) Discounted cash flow c) Introduction
c) Quoted market prices in active d) Decline
markets
d) Average book value 26. Altman Z-score values between 1.81
and 3.0 indicate:
19. What activity includes repurchasing a a) Safe zone
company’s own stock? b) Uncertainty or gray zone
a) Operating c) Insolvency
b) Investing d) Bankruptcy
c) Financing
d) Marketing 27. Which is NOT typically considered a
source of industry risk?
20. ROCE is a measure of: a) Competition
a) Risk exposure b) Technology shifts
b) Market power c) Unionization
c) Profitability relative to capital d) Currency exchange rate changes
employed
d) Creditworthiness 28. Which risk is most relevant when a
country experiences hyperinflation?
21. An increase in accounts receivable a) Firm-specific risk
results in: b) International risk
a) Cash inflow c) Domestic risk
b) Cash outflow d) Bankruptcy risk
c) No effect on cash
d) Expense reduction 29. A firm that generates significant cash
flow from operations is:

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 a) Insolvent b) Operating cash flow to current
b) At credit risk liabilities
c) Financially healthy c) Asset turnover
d) Over-leveraged d) ROCE
30. Which is NOT included in the formula 37. The value of EBIT used in interest
for ROCE? coverage ratio is:
a) Profit margin a) Net profit + taxes
b) Asset turnover b) Earnings before interest and taxes
c) Capital structure leverage c) Earnings after tax
d) Current liabilities d) Net income only
31. What is the formula for quick ratio? 38. Which accounting method better
a) Cash + Receivables / Total liabilities reflects business performance:
b) Current assets – inventory / Equity a) Accrual basis accounting
c) (Current assets – inventory and b) Cash basis accounting
prepaid expenses) / Current liabilities c) FIFO
d) Net sales / Current assets d) LIFO
32. Which risk involves the inability to meet 39. What does Porter's Five Forces NOT
long-term obligations? include?
a) Operating risk a) Threat of substitutes
b) Long-term solvency risk b) Buyer power
c) Credit risk c) Supplier power
d) Liquidity risk d) Government regulation
33. What is considered a limitation of the 40. What is a major source of systematic
balance sheet? risk?
a) Shows too much detail a) Lawsuits
b) Does not include some intangible b) Economic recession
assets c) Fraud
c) Includes future revenue d) Customer returns
d) Is updated weekly
41. In financial analysis, “diffuse rivalry”
34. The return on assets ratio shows: means:
a) Asset efficiency a) High concentration of competitors
b) Profitability relative to assets used b) Numerous small competitors
c) Solvency c) High entry barriers
d) Revenue growth d) Market monopoly
35. An increase in inventory typically leads 42. A deferred tax asset arises when:
to: a) Book income exceeds taxable income
a) Increase in cash permanently
b) Decrease in working capital b) Tax base of an asset exceeds its
c) Cash outflow carrying amount
d) Cash inflow c) Net income is negative
d) Market value exceeds historical cost
36. Which of the following ratios measures
short-term liquidity most 43. The DuPont formula for ROCE includes
comprehensively? all EXCEPT:
a) Debt ratio a) Asset turnover

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 b) Profit margin b) Price variance
c) Capital structure leverage c) Value variance
d) Current ratio d) Contribution margin variance
44. GAAP and IFRS support which model for 51. What does “value variance” in sales
reporting asset values? measure?
a) Pure historical cost a) Quantity differences
b) Pure fair value b) Price fluctuations
c) Mixed attribute model c) Difference in total revenue
d) Constant dollar model d) Cost of production
45. What formula measures profitability per 52. Which is an international risk?
dollar of sales? a) Lawsuit
a) Debt ratio b) Political unrest abroad
b) Profit margin c) Union strikes
c) Asset turnover d) Inflation
d) Quick ratio
53. Which of the following is true about
46. Which of the following is a deductible systematic risk?
temporary difference? a) It affects only one company
a) Non-deductible fines b) It can be eliminated by diversification
b) Prepaid expenses taxed earlier than c) It affects the entire market
expensed d) It is caused by management failure
c) Goodwill impairment
d) Inventory write-off 54. Net income plus depreciation, divided
by total liabilities, is used to assess:
47. Which is not a cash inflow from a) Liquidity
operating activities? b) Solvency
a) Cash sales c) Profitability
b) Interest income d) Bankruptcy
c) Issuing bonds
d) Dividend received 55. What does a low interest coverage ratio
(< 1.0) indicate?
48. High capital structure leverage generally a) Inability to pay interest
leads to: b) High growth
a) Low profitability c) Low risk
b) Reduced risk d) Efficient capital structure
c) Increased financial risk
d) High liquidity 56. Which element is not part of cash flow
forecasting?
49. What does a high working capital a) Expenses
turnover ratio suggest? b) Revenues
a) Efficient use of working capital c) Net income
b) Low profitability d) Shareholder voting rights
c) High fixed assets
d) Over-reliance on credit 57. The contribution margin is used in
calculating:
50. Which variance is calculated as (Actual a) Degree of Operating Leverage
Price – Budgeted Price) × Actual b) Working capital
Volume? c) Interest coverage
a) Sales volume variance d) Inventory turnover

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 58. What kind of item appears in Other 71. Revenue is recognized only when cash is
Comprehensive Income (OCI)? received.
a) Revenue
b) Unrealized gain on securities 72. Long-Term Solvency Risk considers the
c) Cost of goods sold ability to repay debt over time.
d) Interest expense 73. The economic cycle includes peak,
59. A decrease in prepaid expenses would trough, and recession stages.
result in: 74. GAAP and IFRS do not permit the use of
a) Cash outflow hybrid valuation models.
b) Cash inflow
c) Decreased liabilities 75. Credit risk includes the possibility of
d) Increased accounts payable default by borrowers.

60. What happens in the maturity phase of 76. Altman Z-score values below 1.81
a company’s life cycle? indicate low bankruptcy risk.
a) High external funding 77. A firm with high Beta is considered
b) Peak operating performance more volatile than the market.
c) High investment in assets
d) Initial market entry 78. An increase in accounts payable
generally increases cash flow.
TRUE OR FALSE QUESTIONS (61–80)
79. Deferred tax assets arise from
61. The Altman Z-score is used to predict a deductible temporary differences.
firm’s profitability.
80. Extraordinary items are still commonly
62. Short-Term Liquidity Risk is primarily used under current GAAP.
assessed using long-term debt ratios.
ESSAY QUESTIONS (81–100)
63. Financial leverage increases risk but can
also enhance returns. 81. Explain the difference between
systematic risk and firm-specific risk.
64. A Quick Ratio excludes inventory from Provide at least two examples of each.
current assets.
82. Discuss the importance of liquidity
65. The Operating Cash Flow to Current ratios in assessing a company’s financial
Liabilities ratio assesses short-term health.
liquidity.
83. Describe the Altman Z-score model.
66. Unionization is considered an Include its components, thresholds, and
international risk. interpretation.
67. The Statement of Cash Flows includes 84. Explain how cash flow from operating
non-cash transactions directly. activities differs under the direct and
68. Depreciation affects income but not indirect method.
cash flow. 85. Compare and contrast current ratio and
69. Fair value Level 1 is the least reliable in quick ratio. When is each more
the hierarchy. appropriate?

70. A high Interest Coverage Ratio (> 3.5) 86. Describe the impact of high leverage on
indicates low financial risk. a firm’s profitability and risk.

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87. Analyze how Porter’s Five Forces are
used to assess industry competition.
88. Explain the six-step analytical process
in financial statement analysis.
89. Discuss the significance of accrual
accounting in the income statement.
90. Describe how the value chain
contributes to profitability in a business
strategy.
91. Explain the concept and purpose of fair
value hierarchy under SFAS 157.
92. What are the limitations of the balance
sheet, especially regarding non-
monetary assets?
93. Describe how a company’s cash flow
changes across the product life cycle
stages.
94. Define and explain the formula for
Return on Capital Employed (ROCE).
95. Discuss the differences between
financial flexibility and short-term
liquidity.
96. How do deferred tax assets and
liabilities affect income tax expense
reporting?
97. Explain how the statement of cash
flows assists in identifying potential
liquidity issues.
98. Describe the process and benefits of
common-size financial statement
analysis.
99. Explain the difference between
horizontal and vertical competition,
with examples.
100. Discuss how market efficiency COMPLETE ANSWER KEY
affects financial statement analysis and Multiple Choice (1–60):
stock valuation.
1. c
2. b

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3. c 33. b
4. b 34. b
5. c 35. c
6. c 36. b
7. c 37. b
8. b 38. a
9. d 39. d
10. d 40. b
11. c 41. b
12. b 42. b
13. c 43. d
14. d 44. c
15. b 45. b
16. b 46. b
17. c 47. c
18. c 48. c
19. c 49. a
20. c 50. b
21. b 51. c
22. c 52. b
23. b 53. c
24. c 54. b
25. c 55. a
26. b 56. d
27. d 57. a
28. c 58. b
29. c 59. b
30. d 60. b
31. c True or False (61–80):
61. False
32. b 62. False

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 63. True 84. Revenue recognition:
64. True
65. True  Important for accurately reflecting
66. False performance.
67. False  Recognized when earned and realizable
68. True —not when cash is received (accrual
69. False accounting).
70. True
71. False 85. Current vs. Quick Ratio:
72. True  Current Ratio = Current assets / Current
73. True liabilities (includes inventory).
74. False
75. True  Quick Ratio = (Current assets –
76. False inventory – prepaid) / Current liabilities
77. True (more conservative).
78. True
86. High leverage impact:
79. True
80. False  Increases potential return but also
financial risk.
ESSAY
 High debt = higher interest obligations,
81. Difference between systematic and firm-
risk of default in downturns.
specific risk:
87. Porter’s Five Forces:
 Systematic risk affects the entire market
(e.g., inflation, interest rate changes).  Rivalry among firms, threat of new
entrants, threat of substitutes, buyer
 Firm-specific risk is unique to a
power, supplier power.
company (e.g., poor management).
 Used to analyze competition and
 Systematic risk cannot be diversified
profitability of an industry.
away; firm-specific risk can.
88. Six-step analysis process:
82. Altman Z-Score:
1. Industry analysis
 Predicts bankruptcy using five ratios:
working capital/total assets, retained 2. Strategy evaluation
earnings/total assets, EBIT/total assets,
market value of equity/total liabilities, 3. Financial statement quality
and sales/total assets. 4. Profitability and risk
 Z > 3.0 = Safe; Z < 1.81 = Distress. 5. Forecasting
83. Cash flow activities: 6. Valuation
 Operating: Core business activities 89. Accrual accounting:
(sales, salaries).
 Records revenues when earned and
 Investing: Asset purchases/sales expenses when incurred.
(equipment).
 Better matches income with activity,
 Financing: Loans and equity (dividends, improves comparability.
stock).

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90. Value chain and profitability:  Matches taxes to periods they apply to.
 Value is added at each step (production, 97. Statement of cash flows usefulness:
marketing, service).
 Identifies how cash is generated/spent.
 Efficient chains reduce cost and improve
competitive advantage.  Assesses liquidity, financial strength,
and earnings quality.
91. Fair value hierarchy:
98. Common-size analysis:
 Level 1: Quoted prices (most reliable)
 Standardizes items as percentages (e.g.,
 Level 2: Observable inputs % of assets).
 Level 3: Estimates (least reliable)  Allows comparison across firms/time.
92. Balance sheet limitations: 99. Horizontal vs. Vertical competition:
 Omits non-quantifiable assets (e.g.,  Horizontal: Rivalry among similar
brand value). businesses
 Uses historical costs, not always current  Vertical: Buyer/supplier power affecting
market value. cost and terms
93. Cash flow across life cycle: 100. Market efficiency effects:
 Intro: Negative ops/invest, positive  Prices reflect all public info quickly.
financing
 Harder to exploit undervaluation or
 Growth: Rising ops, high investing mispricing.
 Maturity: Positive ops, reduced
investing
 Decline: Asset sales, less financing
94. ROCE formula:
 ROCE = Net profit before interest and
taxes / Capital employed
 Measures efficiency in generating
profits from capital used.
95. Financial flexibility vs. liquidity:
 Liquidity: Meet short-term obligations
 Flexibility: Ability to raise funds in
distress or reallocate resources
96. Deferred tax impact:
 Temporary differences lead to deferred
tax assets or liabilities, adjusting future
tax expense.

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