Analysis of Financial Statements | CBSE Class 12 Accountancy Notes
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This note covers the meaning, significance and objectives of financial statement analysis, the needs of different users, comparative statements, common size statements, trend percentages, ratio analysis, cash flow analysis, worked statement formats and the limitations of financial analysis.
What does analysis of financial statements mean?
Definition: Financial statement analysis is the critical evaluation of financial information contained in financial statements to understand a firm's operations and make decisions about them.
The statement of profit and loss summarises operating results, while the balance sheet presents financial position. Their figures help assess operational efficiency and financial soundness when meaningful relationships are established between the items.
How do analysis and interpretation differ?
Analysis simplifies financial data through methodical classification. Interpretation explains the meaning and significance of that data. The two activities complement each other: simplified figures need explanation, while a sound explanation depends on an organised examination of the figures.
Analysis therefore involves more than reading totals. It regroups information and studies relationships among financial facts. Interpretation uses those relationships to understand profitability, operational efficiency, financial health and future prospects.
The process is judgemental. It evaluates past and current financial positions and operating results to develop estimates about future conditions. These estimates guide decisions; they do not remove the need for judgement about the information and its limitations.
What comparisons can an analyst make?
Cross-sectional analysis compares a firm with other firms. Time-series analysis compares the firm's own performance over a period. Both help reveal strengths and weaknesses that may be less apparent from one statement considered separately.
An annual report contains the balance sheet, statement of profit and loss and cash flow statement. It also includes management's discussion of corporate performance and future prospects. Financial analysis helps users interpret the financial information within this wider report.
The purpose of the enquiry matters. A user concerned with immediate payments may focus on different relationships from a user concerned with future earnings. Selecting and interpreting relevant information connects financial statements with the decision being made.
Why do different users need financial analysis?
Financial strengths and weaknesses matter to management and to outside parties. Owners, trade creditors, lenders, investors, labour unions and analysts may examine the same statements, but their interests differ. A technique useful for one purpose need not serve another purpose equally well.
How does analysis help management?
The finance manager examines managerial performance, corporate efficiency, financial soundness and creditworthiness. Analytical tools help assess operating policies, the investment value of the business, credit ratings and the efficiency of operations.
Analysis also supports financial control. Reviewing actual financial operations helps identify the causes of major deviations and indicates where corrective action may be needed. It connects the examination of accounting information with decisions about running the firm.
Top management has an interest in every aspect of the firm's financial condition. It uses analysis to measure the success of operations, appraise individual performance and evaluate internal control, while seeking efficient use of the firm's resources.
What do outside users examine?
| User | Main interest in financial analysis |
|---|---|
| Trade creditors or trade payables | Short-term payment capacity, liquidity and the continued ability to meet financial obligations. |
| Long-term lenders | Long-term solvency, survival, profitability, cash generation, interest payments, principal repayment and capital structure. |
| Investors | Present and future earnings, capital structure, risk and the efficiency of management. |
| Labour unions | Whether wage increases can be afforded or absorbed through greater productivity or higher prices. |
| Economists and researchers | Present business and economic conditions revealed by financial statements. |
| Government agencies | Information relevant to price regulation, taxation and similar purposes. |
Investors may also assess whether management needs to change. In some large companies, shareholders' interest is limited to deciding whether to buy, sell or hold shares. Their concern is therefore related to both earnings and investment decisions.
Lenders use historical statements to assess future solvency and profitability. Trade creditors place greater emphasis on claims falling due over a very short period. This difference explains why liquidity and long-term survival receive different weights from different users.
What are the objectives and main tools of financial analysis?
The broad objective is to understand the information in financial statements, identify the firm's strengths and weaknesses, and form a view of its future prospects. This supports decisions about operations and further investment in the firm.
Which specific objectives guide the analysis?
- Profitability and efficiency: Assess current profitability and operational efficiency for the firm as a whole and for its departments.
- Composition of financial position: Establish the relative importance of the different components of the firm's financial position.
- Reasons for change: Identify why profitability or financial position has changed between periods.
- Debt repayment: Judge repayment capacity and assess the firm's short-term and long-term liquidity position.
Analysis of several firms also helps economists examine the concentration of economic power and weaknesses in financial policies. It can support governmental decisions relating to licensing, controls, prices, profit ceilings, dividend freezes, tax subsidies and other concessions.
Which five tools are commonly used?
| Tool | What it examines |
|---|---|
| Comparative statements | Amounts for different periods and their absolute and percentage changes. |
| Common size statements | Each item as a percentage of a common base. |
| Trend analysis | Selected financial data over a series of years in relation to a base year. |
| Ratio analysis | Significant relationships between financial statement items. |
| Cash flow analysis | Actual movement of cash into and out of the business. |
Ratio analysis measures the comparative significance of items in income and position statements. It helps assess profitability, solvency and efficiency. The emphasis is on relationships between figures, rather than on an isolated amount.
Cash inflow is cash entering the business; cash outflow is cash leaving it. A cash flow statement shows sources of receipts and purposes of payments during an accounting year, explaining changes in cash between two balance sheet dates.
Net cash flow = Cash inflow − Cash outflow
The tools answer related but different questions. Comparative statements show change, common size statements show composition, and trend analysis gives a longer view. Their usefulness depends on matching the method to the analyst's purpose.
How are comparative financial statements prepared?
Comparative statements place financial information for different periods side by side. They usually take the form of a comparative balance sheet or a comparative statement of profit and loss, showing both the direction and extent of change.
This method is called horizontal analysis. It allows a reader to examine account balances at different dates and operating results for different periods. Absolute changes show the change in money terms; percentage changes relate it to the earlier amount.
What is the preparation sequence?
- List the absolute figures in rupees for the first year and the second year in separate columns.
- Subtract the first-year amount from the second-year amount for each item and identify the increase or decrease.
- Calculate the percentage change by dividing the absolute change by the first-year figure and multiplying by 100.
Absolute change = Second-year amount − First-year amount
Percentage change = Absolute change ÷ First-year amount × 100
| Column | Content | Purpose |
|---|---|---|
| 1 | Particulars | Identifies the financial statement item. |
| 2 | First-year amount | Provides the comparison base in rupees. |
| 3 | Second-year amount | Shows the later amount in rupees. |
| 4 | Absolute increase or decrease | Shows the monetary change. |
| 5 | Percentage increase or decrease | Shows the change relative to the first year. |
Why must accounting principles be consistent?
Financial data are comparable when the statements use the same accounting principles. If principles differ, the deviation should be mentioned in a footnote. Otherwise, a change caused by accounting treatment may be mistaken for a change in performance.
Note: The denominator for percentage change is the first-year amount. Keep the direction of the change visible: a fall must appear as a decrease, not as a positive increase.
A comparative statement is therefore both a calculation and a basis for interpretation. Reading the absolute and percentage columns together helps identify changes in financial position and operating results without losing sight of the original amounts.
How is a comparative statement of profit and loss worked out?
A comparative statement of profit and loss follows the movement from revenue through expenses and tax to profit after tax. Each item has an earlier amount, a later amount, an absolute change and a percentage change.
Worked example 1. Madhu Co. Ltd. has revenue from operations of ₹16,00,000 and ₹20,00,000, employee benefit expenses of ₹8,00,000 and ₹10,00,000, and other expenses of ₹2,00,000 and ₹1,00,000 for 2015-16 and 2016-17 respectively. Tax is 40% in both years. Prepare the comparative statement.
Answer: Profit before tax is ₹16,00,000 − ₹8,00,000 − ₹2,00,000 = ₹6,00,000 in 2015-16 and ₹20,00,000 − ₹10,00,000 − ₹1,00,000 = ₹9,00,000 in 2016-17.
Tax is ₹6,00,000 × 40% = ₹2,40,000 and ₹9,00,000 × 40% = ₹3,60,000. Profit after tax is therefore ₹3,60,000 and ₹5,40,000 respectively.
Comparative statement of profit and loss of Madhu Co. Ltd.
For the years ended 31 March 2016 and 31 March 2017. Amounts are in rupees; parentheses show decreases in the change columns.
| Particulars | 2015-16 ₹ | 2016-17 ₹ | Absolute change ₹ | Change % |
|---|---|---|---|---|
| Revenue from operations | 16,00,000 | 20,00,000 | 4,00,000 | 25 |
| Less: Employee benefit expenses | 8,00,000 | 10,00,000 | 2,00,000 | 25 |
| Less: Other expenses | 2,00,000 | 1,00,000 | (1,00,000) | (50) |
| Profit before tax | 6,00,000 | 9,00,000 | 3,00,000 | 50 |
| Less: Tax at 40% | 2,40,000 | 3,60,000 | 1,20,000 | 50 |
| Profit after tax | 3,60,000 | 5,40,000 | 1,80,000 | 50 |
How should the changes be interpreted?
Revenue from operations increases by ₹4,00,000, or 25%. Employee benefit expenses rise by the same percentage, but other expenses fall by ₹1,00,000, or 50%. Profit before tax consequently rises by ₹3,00,000, or 50%.
The tax rate remains 40%, so tax and profit after tax both rise by 50%. The profit-after-tax calculation is ₹1,80,000 ÷ ₹3,60,000 × 100 = 50%. This percentage uses the earlier profit, not the later profit or revenue.
The statement shows that revenue growth and expense changes must be read together. Looking at revenue alone would not reveal the different movement in other expenses or explain the full change in profit.
How does a comparative balance sheet show financial change?
A comparative balance sheet compares financial position at two dates. It retains the distinction between equity and liabilities on one side and assets on the other, while adding columns for absolute and percentage changes.
Worked example 2. Prepare J. Ltd.'s comparative balance sheet at 31 March 2016 and 31 March 2017 using the first two amount columns below. All amounts, including changes, are in ₹ lakh.
Answer: Total equity and liabilities increase from ₹27 lakh to ₹35 lakh. The increase is ₹8 lakh, and ₹8 lakh ÷ ₹27 lakh × 100 = 29.63%, rounded to two decimal places. Total assets show the same increase.
Comparative balance sheet of J. Ltd.
| Equity and liabilities | 31 March 2016 ₹ lakh | 31 March 2017 ₹ lakh | Change ₹ lakh | Change % |
|---|---|---|---|---|
| Shareholders' funds: Share capital | 15 | 20 | 5 | 33.33 |
| Shareholders' funds: Reserves and surplus | 4 | 3 | (1) | (25) |
| Non-current liabilities: Long-term borrowings | 6 | 9 | 3 | 50 |
| Current liabilities: Trade payables | 2 | 3 | 1 | 50 |
| Total equity and liabilities | 27 | 35 | 8 | 29.63 |
| Assets | 31 March 2016 ₹ lakh | 31 March 2017 ₹ lakh | Change ₹ lakh | Change % |
|---|---|---|---|---|
| Non-current assets: Tangible fixed assets | 15 | 20 | 5 | 33.33 |
| Non-current assets: Intangible fixed assets | 6 | 9 | 3 | 50 |
| Current assets: Inventories | 4 | 3 | (1) | (25) |
| Current assets: Cash and cash equivalents | 2 | 3 | 1 | 50 |
| Total assets | 27 | 35 | 8 | 29.63 |
What do the individual rows reveal?
Share capital rises by ₹5 lakh: 5 ÷ 15 × 100 = 33.33%. Long-term borrowings rise by ₹3 lakh: 3 ÷ 6 × 100 = 50%. The larger percentage belongs to the smaller absolute increase because the starting amounts differ.
Reserves and surplus fall by ₹1 lakh, or 25%. Inventories also fall by ₹1 lakh, or 25%. These decreases must remain visible even though the overall balance sheet total increases.
The totals reconcile: equity and liabilities are 15 + 4 + 6 + 2 = ₹27 lakh and 20 + 3 + 9 + 3 = ₹35 lakh. Assets are 15 + 6 + 4 + 2 = ₹27 lakh and 20 + 9 + 3 + 3 = ₹35 lakh.
How do common size statements differ from comparative statements?
A common size statement, also called a component percentage statement, expresses each financial item as a percentage of a common base. This is vertical analysis, because it examines the structure of a statement through the relative importance of its components.
In a common size statement of profit and loss, the base is revenue from operations. In a common size balance sheet, total assets form the asset-side base; total equity and liabilities provide the corresponding equal total on the financing side.
How is a common size statement prepared?
- List the absolute amounts for the periods or firms being compared.
- Select the appropriate common base and treat that base as 100.
- Express each amount as a percentage of its corresponding base and place the percentages beside the absolute figures.
Common size percentage = Item amount ÷ Common base amount × 100
The statement retains the original amounts while adding percentages. Each year's percentages must use that year's base. The result makes changes in composition easier to examine across periods and across companies of different sizes in the same industry.
Comparison of the two methods
| Basis | Comparative statement | Common size statement |
|---|---|---|
| Other name | Horizontal analysis | Vertical analysis |
| Main focus | Change between periods | Relationship of items to a common base |
| Percentage denominator | The first-year amount of the same item | The relevant common total for that statement |
| Additional information | Absolute and percentage increases or decreases | Component percentages alongside absolute amounts |
| Usefulness | Direction and extent of changes in financial position and results | Composition and comparison within a firm or between firms of different sizes |
Intra-firm comparison examines one company across periods. Inter-firm comparison examines different companies. Common size analysis is useful for both, because absolute amounts are brought to a common percentage basis.
Note: In a common size statement of profit and loss, use revenue from operations as 100. Do not replace it with total revenue merely because other income appears in the statement.
How is a common size statement of profit and loss calculated?
A common size profit statement shows how revenue, expenses and profits relate to revenue from operations. It can reveal a change in relative profitability even when the absolute revenue or profit moves in a different direction.
Worked example 3. For 2015-16 and 2016-17 respectively, revenue from operations is ₹25,00,000 and ₹20,00,000; other income is ₹3,25,000 and ₹2,50,000; employee benefit expenses are ₹8,25,000 and ₹4,50,000; and other expenses are ₹2,00,000 and ₹1,00,000. Tax on profit before tax is 30% and 20% respectively.
Answer: Total revenue is ₹28,25,000 and ₹22,50,000. Deducting the two expense items gives profit before tax of ₹18,00,000 and ₹17,00,000. Tax is ₹5,40,000 and ₹3,40,000, leaving profit after tax of ₹12,60,000 and ₹13,60,000.
Common size statement for the years ended 31 March 2016 and 2017
| Particulars | 2015-16 ₹ | 2016-17 ₹ | 2015-16 % of operations revenue | 2016-17 % of operations revenue |
|---|---|---|---|---|
| Revenue from operations | 25,00,000 | 20,00,000 | 100 | 100 |
| Add: Other income | 3,25,000 | 2,50,000 | 13 | 12.5 |
| Total revenue | 28,25,000 | 22,50,000 | 113 | 112.5 |
| Less: Employee benefit expenses | 8,25,000 | 4,50,000 | 33 | 22.5 |
| Less: Other expenses | 2,00,000 | 1,00,000 | 8 | 5 |
| Profit before tax | 18,00,000 | 17,00,000 | 72 | 85 |
| Less: Tax | 5,40,000 | 3,40,000 | 21.6 | 17 |
| Profit after tax | 12,60,000 | 13,60,000 | 50.4 | 68 |
Why are the tax percentages different from the tax rates?
The tax rate is applied to profit before tax. The common size tax percentage relates the resulting tax expense to revenue from operations. Thus, ₹5,40,000 ÷ ₹25,00,000 × 100 = 21.6%, although the tax rate is 30%.
For 2016-17, ₹3,40,000 ÷ ₹20,00,000 × 100 = 17%, although the tax rate is 20%. Keeping these two bases separate is essential to reproducing the statement correctly.
Profit before tax falls from ₹18,00,000 to ₹17,00,000, but its share of revenue from operations rises from 72% to 85%. Profit after tax rises both in amount and as a share of revenue, from 50.4% to 68%.
Total revenue exceeds 100% because the base includes revenue from operations, while total revenue also includes other income. This is consistent with the chosen base and does not indicate an error in the statement.
How can common size balance sheets compare two companies?
Common size balance sheets help compare financial structures when absolute totals differ. A larger amount by itself does not show whether an item occupies a larger proportion of a company's total assets or financing.
Worked example 4. Aditya Ltd. has equity share capital ₹6,00,000, reserves and surplus ₹3,00,000, current liabilities ₹1,00,000, fixed assets ₹4,00,000 and current assets ₹6,00,000. Anjali Ltd. has corresponding amounts of ₹8,00,000, ₹2,50,000, ₹1,50,000, ₹7,00,000 and ₹5,00,000. Prepare common size balance sheets.
Answer: Aditya Ltd.'s total is ₹10,00,000 and Anjali Ltd.'s total is ₹12,00,000. Divide each company's items by its own total and multiply by 100. For example, their fixed assets are 40% and 58.33% respectively.
Common size balance sheets of Aditya Ltd. and Anjali Ltd.
Percentages are rounded to two decimal places where necessary. The equity and liabilities total and the assets total each represent 100% for the relevant company.
| Equity and liabilities | Aditya Ltd. ₹ | Anjali Ltd. ₹ | Aditya Ltd. % | Anjali Ltd. % |
|---|---|---|---|---|
| Shareholders' funds: Equity share capital | 6,00,000 | 8,00,000 | 60 | 66.67 |
| Shareholders' funds: Reserves and surplus | 3,00,000 | 2,50,000 | 30 | 20.83 |
| Current liabilities | 1,00,000 | 1,50,000 | 10 | 12.50 |
| Total equity and liabilities | 10,00,000 | 12,00,000 | 100 | 100 |
| Assets | Aditya Ltd. ₹ | Anjali Ltd. ₹ | Aditya Ltd. % | Anjali Ltd. % |
|---|---|---|---|---|
| Non-current assets: Fixed assets | 4,00,000 | 7,00,000 | 40 | 58.33 |
| Current assets | 6,00,000 | 5,00,000 | 60 | 41.67 |
| Total assets | 10,00,000 | 12,00,000 | 100 | 100 |
What comparisons follow from the percentages?
Aditya Ltd.'s current assets represent 60% of total assets. Anjali Ltd.'s represent ₹5,00,000 ÷ ₹12,00,000 × 100 = 41.67%. The comparison describes the composition of assets after allowing for the different totals.
Anjali Ltd.'s equity share capital is ₹8,00,000 ÷ ₹12,00,000 × 100 = 66.67% of its total. Its reserves and surplus are 20.83%, and current liabilities are 12.50%. Aditya Ltd.'s corresponding shares are 60%, 30% and 10%.
The calculation must use a separate base for each company. Using Aditya Ltd.'s total for Anjali Ltd.'s items would no longer express those items as proportions of Anjali Ltd.'s own financial position.
How do trend percentages help interpret performance over time?
Trend analysis examines operating results and financial position over a series of years. It uses earlier financial data to observe percentage movements in selected items and provides a longer view of changes in the business.
A trend percentage relates the amount of an item in a particular year to the amount of the same item in the base year. Keeping the base fixed allows successive years to be compared on the same footing.
Trend percentage = Year's item amount ÷ Base-year item amount × 100
What does a trend show?
Trend analysis may point to basic changes in the nature of a business. Looking at a ratio over time can show whether it is rising, falling or remaining relatively constant. Such movements may identify a problem or indicate good or poor management.
The emphasis is on the series of years. A comparative statement shows changes between the periods displayed, while a trend relates each selected year's figure to a common base-year figure. The base must refer to the same item being studied.
How is a trend percentage different from percentage change?
The numerator in a comparative percentage change is the increase or decrease. The numerator in a trend percentage is the year's full amount. The formulas therefore express different relationships even when the same earlier year supplies their denominator.
Trend analysis assists interpretation but remains part of a judgemental process. Its longer view helps an analyst recognise movements that need explanation. Understanding those movements still requires attention to the accounting information and the purpose of the analysis.
It is useful to connect trends with the objectives of analysis: assessing profitability and efficiency, understanding financial position, identifying reasons for change and judging repayment capacity. The trend supplies evidence for these enquiries rather than replacing them.
What limitations must be considered when interpreting financial analysis?
Financial analysis is based on information available in financial statements. It therefore inherits their limitations. A carefully calculated percentage can still mislead if the underlying information or the basis on which it was prepared is misunderstood.
Which limitations affect the conclusions?
- Price level changes: Financial analysis does not consider changes in price levels.
- Accounting procedures: Analysis may be misleading when changes in the procedures followed by a firm are not known.
- Dependence on reports: The analysis is a study of the company's reports and depends on the information available in them.
- Non-monetary aspects: Monetary information is considered, while non-monetary aspects are ignored.
- Accounting concepts: Statements are prepared on the basis of accounting concepts and do not reflect the current position in every respect.
An analyst must also be conscious of window dressing, accounting conventions and personal judgement. These affect the information used for analysis and need attention when assessing what the reported figures mean.
How should these limitations influence interpretation?
The requirement for consistent accounting principles is particularly important in comparisons. If the principles used have changed, the deviation should be disclosed. Without that knowledge, conclusions about changes in profitability or financial position may be misleading.
The monetary focus also limits what can be inferred from ratios and percentages. Financial analysis helps identify strengths, weaknesses and possible future prospects, but its scope remains tied to the information contained in financial reports.
Useful interpretation therefore combines correct calculation with awareness of purpose and limitations. The analyst should explain what the relationships reveal while recognising the effects of accounting policies, price changes and judgement on the reported figures.
Glossary
- Financial statement analysis — Critical evaluation of financial information to understand operations and support decisions about a firm.
- Analysis — Simplification of financial data through methodical classification of information contained in financial statements.
- Interpretation — Explanation of the meaning and significance of financial data after it has been analysed.
- Comparative statements — Statements displaying financial amounts for different periods with absolute and percentage changes.
- Common size statements — Statements expressing each financial item as a percentage of an appropriate common base.
- Horizontal analysis — Analysis using comparative financial statements to examine changes across different periods of time.
- Vertical analysis — Analysis expressing items within a financial statement in relation to a common base.
- Trend analysis — Study of operating results and financial position over a series of years.
- Ratio analysis — Examination of significant relationships between financial statement items to assess profitability, solvency and efficiency.
- Cash flow analysis — Examination of actual movements of cash into and out of a business.
- Intra-firm comparison — Comparison of a firm's own financial results or position over different periods.
- Inter-firm comparison — Comparison of the financial information of different firms to assess their relative position.
Common errors and misconceptions
- Misconception: Analysis and interpretation mean exactly the same thing. Correct: Analysis simplifies and classifies data; interpretation explains its meaning and significance.
- Misconception: Financial analysis is useful only to creditors. Correct: Management, investors, lenders, labour unions, researchers and government agencies also use it for different purposes.
- Misconception: Comparative percentage change uses the second-year amount as its base. Correct: Divide the change by the first-year amount and multiply by 100.
- Misconception: Total revenue must be 100% in a common size profit statement. Correct: Revenue from operations is the base; total revenue can exceed 100% when other income is added.
- Misconception: The tax rate and common size tax percentage are identical. Correct: Tax is calculated on profit before tax, whereas its common size percentage uses revenue from operations.
- Misconception: A common size balance sheet uses the same rupee denominator for every company. Correct: Each company uses its own relevant total as the base.
- Misconception: Exact arithmetic removes every limitation of financial analysis. Correct: Price levels, accounting policies, window dressing, judgement and omitted non-monetary information still affect interpretation.
Exam-style questions with model answers
Q1. Distinguish between analysis and interpretation of financial statements. [2 marks]
- Analysis simplifies financial data by methodically classifying the information contained in financial statements.
- Interpretation explains the meaning and significance of that data. Both activities complement one another in supporting decisions.
Q2. Explain three reasons why a long-term lender analyses a firm's financial statements. [3 marks]
- A long-term lender examines solvency and survival to assess whether the firm is likely to remain capable of meeting its obligations.
- The lender studies profitability over time and cash-generating ability because interest payments and repayment of principal depend on the firm's financial capacity.
- The lender also studies relationships between sources of funds, using historical statements to assess future solvency and profitability.
Q3. Explain the four specific objectives of financial statement analysis. [4 marks]
- Assess current profitability and operational efficiency for the firm as a whole and for its different departments to judge financial health.
- Determine the relative importance of the different components of financial position, making the composition of the firm's finances clearer.
- Identify the reasons for changes in profitability or financial position, so that movements in reported results can be understood.
- Judge the firm's ability to repay debt and assess its short-term as well as long-term liquidity position.
Q4. Madhu Co. Ltd.'s revenue from operations is ₹16,00,000 in 2015-16 and ₹20,00,000 in 2016-17. Employee benefit expenses are ₹8,00,000 and ₹10,00,000, and other expenses are ₹2,00,000 and ₹1,00,000 respectively. Tax is 40% of profit before tax in both years. Calculate profit before tax, tax and profit after tax for each year, and the absolute and percentage increase in profit after tax. [5 marks]
- Profit before tax for 2015-16 is ₹16,00,000 − ₹8,00,000 − ₹2,00,000 = ₹6,00,000, after deducting both categories of expenses from revenue.
- Profit before tax for 2016-17 is ₹20,00,000 − ₹10,00,000 − ₹1,00,000 = ₹9,00,000, using the corresponding amounts for the second year.
- Tax is calculated on profit before tax: ₹6,00,000 × 40% = ₹2,40,000 and ₹9,00,000 × 40% = ₹3,60,000 respectively.
- Profit after tax is ₹6,00,000 − ₹2,40,000 = ₹3,60,000 for 2015-16 and ₹9,00,000 − ₹3,60,000 = ₹5,40,000 for 2016-17.
- The absolute increase is ₹5,40,000 − ₹3,60,000 = ₹1,80,000. The percentage increase is ₹1,80,000 ÷ ₹3,60,000 × 100 = 50%, using first-year profit as the base.
Q5. For 2016-17, revenue from operations is ₹20,00,000, other income ₹2,50,000, employee benefit expenses ₹4,50,000 and other expenses ₹1,00,000. Tax is 20% of profit before tax. Calculate total revenue, profit before tax, tax and profit after tax, and express each as a percentage of revenue from operations. [4 marks]
- Total revenue is ₹20,00,000 + ₹2,50,000 = ₹22,50,000. Its common size percentage is ₹22,50,000 ÷ ₹20,00,000 × 100 = 112.5%.
- Profit before tax is ₹22,50,000 − ₹4,50,000 − ₹1,00,000 = ₹17,00,000. Its percentage is ₹17,00,000 ÷ ₹20,00,000 × 100 = 85%.
- Tax is ₹17,00,000 × 20% = ₹3,40,000. As a percentage of revenue from operations it is 17%, rather than the 20% tax rate.
- Profit after tax is ₹17,00,000 − ₹3,40,000 = ₹13,60,000. Its common size percentage is ₹13,60,000 ÷ ₹20,00,000 × 100 = 68%.
Q6. Explain five limitations of financial analysis. [5 marks]
- Financial analysis does not consider price level changes. The analyst must therefore be conscious of their impact when interpreting financial information and comparisons.
- It may be misleading without knowledge of changes in accounting procedures. Differences in the basis of preparation affect the meaning of comparisons.
- It is a study of company reports and depends on the information those reports contain. The limitations of that information also affect analysis.
- It considers monetary information while ignoring non-monetary aspects. Its conclusions therefore reflect the financial information available rather than every aspect of the business.
- Financial statements are based on accounting concepts and do not fully reflect the current position. Accounting conventions and personal judgement also require attention during interpretation.
Q7. Anjali Ltd. has equity share capital ₹8,00,000, reserves and surplus ₹2,50,000, current liabilities ₹1,50,000, fixed assets ₹7,00,000 and current assets ₹5,00,000. Calculate the common size percentages of equity share capital, reserves and surplus, and current liabilities, rounding to two decimal places. [3 marks]
- The common financing total is ₹8,00,000 + ₹2,50,000 + ₹1,50,000 = ₹12,00,000. Equity share capital is ₹8,00,000 ÷ ₹12,00,000 × 100 = 66.67%.
- Reserves and surplus are ₹2,50,000 ÷ ₹12,00,000 × 100 = 20.83%, using the same company total as the base.
- Current liabilities are ₹1,50,000 ÷ ₹12,00,000 × 100 = 12.50%. The three rounded financing percentages together total 100%.
Key takeaways
- Financial analysis establishes relationships among statement items, while interpretation explains what those relationships mean for decisions.
- The purpose of the user determines which financial relationships and analytical tools deserve the greatest attention.
- Comparative statements show absolute and percentage changes, with percentage change calculated using the first-year amount.
- Common size profit statements use revenue from operations as their base, even when other income is present.
- Common size balance sheets express components against each company's own total, allowing comparison despite differences in size.
- Trend percentages relate each year's amount to the same item in a fixed base year.
- Correct tax calculations distinguish the tax rate on profit before tax from tax as a percentage of revenue.
- Financial analysis inherits limitations arising from reporting, accounting policies, price changes, judgement and the exclusion of non-monetary aspects.
Test yourself
What are the five commonly used tools of financial analysis?
They are comparative statements, common size statements, trend analysis, ratio analysis and cash flow analysis.
Why is comparative statement analysis called horizontal analysis?
It compares financial amounts across different periods and examines their absolute and percentage changes.
What is the common base in a common size statement of profit and loss?
Revenue from operations is taken as 100, and other items are expressed as percentages of it.
What is the main concern of trade creditors?
They focus on liquidity and the firm's ability to meet claims over a very short period.
How does inter-firm comparison differ from intra-firm comparison?
Inter-firm comparison examines different firms; intra-firm comparison examines one firm's own financial information across periods.
What does a cash flow statement explain?
It explains changes in cash between balance sheet dates through sources of receipts and purposes of payments.
What must be disclosed when accounting principles used in comparative statements differ?
The deviation in accounting principles should be mentioned in a footnote to support meaningful comparison.
Does a rising balance sheet total mean that every individual item increased?
No. Individual items may decrease even when the total increases, so each comparative row needs examination.