Financial Statement Analysis | ISC Class 12 Accounts Notes

This note covers the meaning, significance and limitations of comparative statements and common size statements, the step-by-step preparation of a comparative balance sheet and comparative statement of profit and loss showing absolute and percentage change, the preparation of a common size balance sheet (as a percentage of total assets and total liabilities) and a common size statement of profit and loss (as a percentage of revenue from operations), and the difference between inter-firm and intra-firm comparison.

What is financial statement analysis?

Financial statement analysis is the process of critical evaluation of the financial information contained in the financial statements in order to understand and make decisions regarding the operations of the firm.

It is a study of the relationship among various financial facts and figures given in a set of financial statements, and the interpretation of that relationship to gain an insight into the profitability and operational efficiency of the firm.

The term "financial analysis" includes both analysis and interpretation. Analysis means simplification of financial data by methodical classification given in the financial statements. Interpretation means explaining the meaning and significance of the data.

These two are complementary to each other: analysis is useless without interpretation, and interpretation without analysis is difficult or even impossible.

Definition: Analysis and interpretation. Analysis is the methodical simplification and classification of data given in financial statements. Interpretation is explaining the meaning and significance of that simplified data. Analysis without interpretation and interpretation without analysis both fail to serve the purpose of financial statement analysis.

Financial statement analysis is a judgemental process that aims to estimate the current and past financial position and the results of operation of an enterprise, with the primary objective of determining the best possible estimates and predictions about future conditions.

It involves regrouping and analysing the information in financial statements to establish relationships and show the points of strengths and weaknesses of a business, which is useful in decision-making involving comparison with other firms and with the firm's own performance over time.

Why is financial statement analysis significant, and who uses it?

Financial analysis identifies the financial strengths and weaknesses of a firm by properly establishing relationships between the various items of the balance sheet and the statement of profit and loss.

It can be undertaken by the management of the firm or by parties outside the firm.

The nature of analysis differs depending on the purpose of the analyst, since a technique used by one analyst need not serve the purpose of another because of differing interests.

• Finance manager: uses analysis to study managerial performance, corporate efficiency, financial strengths and weaknesses and creditworthiness, and for financial control by reviewing actual operations against policy.
• Top management: uses analysis to measure the success of operations, appraise individual performance and evaluate the system of internal control.
• Trade payables: appraise the firm's ability to meet short-term obligations, so their analysis evaluates the firm's liquidity position.
• Lenders of long-term debt: analyse profitability, cash generation, ability to pay interest and repay principal, and the capital structure relationship, to assess future solvency.
• Investors: concentrate on present and future profitability and on capital structure to see its influence on earnings and risk, and to decide whether to buy, sell or hold shares.
• Labour unions: assess whether the firm can afford a wage increase, and whether this can be absorbed through productivity or price rises.
• Others: economists, researchers and government agencies use the analysis to study business conditions, and for price regulation, taxation and similar purposes.

The objectives of financial statement analysis are to assess the current profitability and operational efficiency of the firm as a whole and of its departments; to ascertain the relative importance of different components of the financial position; to identify the reasons for change in profitability or financial position; and to judge the firm's ability to repay its debt by assessing both its short-term and long-term liquidity position.

What are comparative statements, and what are their significance and limitations?

Meaning of comparative statements

Comparative statements are the statements showing the profitability and financial position of a firm for different periods of time in a comparative form, to give an idea about the position in two or more periods.

They apply usually to the two important financial statements: the balance sheet and the statement of profit and loss, prepared in a comparative form. This analysis is also known as horizontal analysis.

Definition: Comparative statements. Statements that show figures for two or more accounting periods side by side along with the absolute change and percentage change between them, so as to identify the direction and trend of the firm's financial position and operating results.

Merits of comparative statements

Comparative figures indicate the trend and direction of financial position and operating results. The financial data are comparative only when the same accounting principles are used in preparing the statements for both periods.

If accounting principles differ between the two periods, the deviation should be mentioned as a footnote so that the comparison is not misread.

The significance of comparative statements goes further than showing a single change. Because the figures of two or more years are placed side by side, the analyst can see whether an item is rising, falling or holding steady across the years, and so judge the direction in which the business is moving.

They help to identify the points of weakness as well as the points of strength of the firm: an expense that grows faster than revenue, or a liability that rises while assets stand still, stands out clearly once the absolute and percentage changes are set out.

They also support decision-making, because the comparison of one period with another, and of one firm with another, gives the management and outside parties a basis for judging performance and for choosing a course of action.

Limitations of comparative statements

Comparative statements are only meaningful when the same accounting principles are applied consistently across the periods being compared. Where this is not the case, the comparison can be misleading unless the change in principle is disclosed by way of a footnote.

They do not consider price level changes, so a rise in figures caused only by inflation can look like real growth. They can also be distorted by window dressing, by a change in accounting policy between the two periods, and by the fact that they rest on monetary figures alone and ignore non-monetary factors.

How do you prepare a comparative balance sheet or comparative statement of profit and loss?

Comparative statements refer to the statement of profit and loss and the balance sheet prepared with columns for the figures of the current year, the previous year, and the changes during the year in both absolute and relative (percentage) terms. The following steps are followed:

1. List the absolute figures in rupees for the two periods being compared (the first year and the second year).
2. Find the change in absolute figures by subtracting the first year figure from the second year figure, and show the change as an increase (+) or decrease (−).
3. Calculate the percentage change using the absolute change and the first year figure as the base.

Absolute Change = Second year − First year. This figure is also called the absolute increase (+) or decrease (−) in an item between the two periods compared.

Percentage Change = (Absolute Change ÷ First year figure) × 100. The first year's figure is always used as the base (denominator), whichever two periods are being compared.

Worked example 1. The statement of profit and loss of BCR Co. Ltd. showed revenue from operations of ₹60,00,000 in 2015-16 and ₹75,00,000 in 2016-17; other incomes of ₹1,50,000 and ₹1,20,000; expenses of ₹44,00,000 and ₹50,60,000; and an income tax rate of 35% and 40% respectively. Prepare the comparative statement of profit and loss.

Answer: Total revenue = revenue from operations + other income = ₹61,50,000 (2015-16) and ₹76,20,000 (2016-17), an absolute increase of ₹14,70,000, or 23.90%.

Profit before tax = total revenue − expenses = ₹17,50,000 and ₹25,60,000, an increase of ₹8,10,000, or 46.29%. Tax (at 35% and 40%) = ₹6,12,500 and ₹10,24,000, an increase of ₹4,11,500, or 67.18%.

Profit after tax = ₹11,37,500 and ₹15,36,000, an increase of ₹3,98,500, or 35.03%.

For a comparative balance sheet, the same three steps are applied item by item to the Equity and Liabilities side and the Assets side, keeping the Schedule III grouping of shareholders' funds, non-current liabilities, current liabilities, non-current assets and current assets that companies incorporated in India use under Schedule III of the Companies Act, 2013.

Total Assets = Total Liabilities. In a correctly prepared comparative balance sheet, the total of the equity and liabilities side and the total of the assets side must show the same absolute change and the same percentage change in both years, which is a useful check on the working.

Worked example 2. J. Ltd., a company incorporated in India and following Schedule III of the Companies Act, 2013, had the following balances as at 31 March 2016 and 2017 (₹): share capital 15,00,000 and 20,00,000; reserves and surplus 4,00,000 and 3,00,000; long-term borrowings 6,00,000 and 9,00,000; trade payables 2,00,000 and 3,00,000; tangible assets 15,00,000 and 20,00,000; intangible assets 6,00,000 and 9,00,000; inventories 4,00,000 and 3,00,000; cash and cash equivalents 2,00,000 and 3,00,000. Prepare the comparative balance sheet, working in ₹ lakhs.

Answer: Step 1, list the absolute figures for 2016 and 2017 in ₹ lakhs: share capital 15 and 20; reserves and surplus 4 and 3; long-term borrowings 6 and 9; trade payables 2 and 3; tangible assets 15 and 20; intangible assets 6 and 9; inventories 4 and 3; cash and cash equivalents 2 and 3.

Step 2, find the absolute change (2017 − 2016) in ₹ lakhs: share capital +5; reserves and surplus −1; long-term borrowings +3; trade payables +1; tangible assets +5; intangible assets +3; inventories −1; cash and cash equivalents +1.

Step 3, express each absolute change as a percentage of the 2016 figure: share capital 33.33%; reserves and surplus (25%) (a decrease); long-term borrowings 50%; trade payables 50%; tangible assets 33.33%; intangible assets 50%; inventories (25%) (a decrease); cash and cash equivalents 50%.

Total equity and liabilities rise from ₹27 lakh to ₹35 lakh, an increase of ₹8 lakh, or 29.63%, which equals the increase shown by total assets, confirming that total assets equal total liabilities in both years.

Draw a bar chart with the balance sheet items (share capital, reserves, borrowings, trade payables, fixed assets, inventories) along the x-axis and the percentage change (column 5 of the comparative statement) along the y-axis, with one bar per item, to show visually which items have grown fastest and which have fallen.

What is inter-firm and intra-firm comparison using comparative statements?

A comparative statement can be prepared for the same firm across two accounting periods, which is called intra-firm comparison (comparing the firm with itself over time), or for two different firms for the same period, which is called inter-firm comparison (comparing one firm with another).

Both comparisons use the same three-step method: absolute figures, absolute change and percentage change.

How is an inter-firm comparative statement prepared?

For an inter-firm comparison, the figures of the two firms for the same period are placed side by side, and the absolute change and percentage change are worked out in the same way as for one firm over two years. The first firm's figure is taken as the base, and the second firm's figure is compared with it.

Worked example 6. Aditya Ltd. and Anjali Ltd. reported the following figures for the same year (₹): equity share capital 6,00,000 and 8,00,000; reserves and surplus 3,00,000 and 2,50,000; current liabilities 1,00,000 and 1,50,000; fixed assets 4,00,000 and 7,00,000; current assets 6,00,000 and 5,00,000; total 10,00,000 and 12,00,000. Prepare an inter-firm comparative balance sheet.

Answer: Step 1, list the figures of both firms side by side for the same year, as given above.

Step 2, find the absolute change (Anjali Ltd. − Aditya Ltd.): equity share capital +2,00,000; reserves and surplus −50,000; current liabilities +50,000; fixed assets +3,00,000; current assets −1,00,000; total +2,00,000.

Step 3, express each change as a percentage of Aditya Ltd.'s figure: equity share capital 33.33%; reserves and surplus (16.67%); current liabilities 50%; fixed assets 75%; current assets (16.67%); total 20%.

The comparison shows that Anjali Ltd. is the larger firm, and that its extra funds are held mainly in fixed assets, while its current assets are lower than those of Aditya Ltd.

What are common size statements, and what are their significance and limitations?

Meaning of common size statements

A common size statement, also known as a component percentage statement, is a financial tool for studying the key changes and trends in the financial position and operational result of a company.

Each item in the statement is stated as a percentage of the aggregate, or of the revenue from operations of which that item is a part. This analysis is also known as vertical analysis.

Definition: Common size statement. A statement in which every item of the balance sheet or the statement of profit and loss is expressed as a percentage of a common base (total assets or total liabilities for the balance sheet, revenue from operations for the statement of profit and loss), so that firms of different sizes can be compared.

Merits of common size statements

Common size analysis is of immense use for comparing enterprises that differ substantially in size, as it provides insight into the structure of financial statements.

The percentages calculated can be compared with the corresponding percentages of a previous year or of another firm, since all numbers are brought to a common base.

Inter-firm comparison, or comparison of a company's position with the industry as a whole, is possible with the help of common size statement analysis.

Limitations of common size statements

Like comparative statements, common size statements are reliable only if the firms or periods being compared have used consistent accounting policies; beyond this, common size statements share the general limitations of financial statement analysis described below.

How do you prepare a common size balance sheet?

The procedure for preparing common size statements is:

1. List the absolute figures in rupees for the two periods being compared.
2. Choose a common base of 100: total assets or total liabilities for the balance sheet, and revenue from operations for the statement of profit and loss.
3. Work out the percentage of the total for every item in both periods, using the common base.

Common Size Percentage = Item ÷ Base × 100. For a balance sheet the base is total assets, which is equal in value to total liabilities, since both sides of a balance sheet always total to the same figure.

Worked example 3. XRI Ltd., a company incorporated in India, had the following balance sheet as at 31 March 2016 and 2017 (₹): share capital 15,00,000 and 12,00,000; reserves and surplus 5,00,000 and 5,00,000; long-term borrowings 6,00,000 and 5,00,000; trade payables 15,50,000 and 10,50,000 (total 41,50,000 and 32,50,000); plant and machinery 14,00,000 and 8,00,000; goodwill 16,00,000 and 12,00,000; non-current investments 10,00,000 each year; inventories 1,50,000 and 2,50,000. Prepare the common size balance sheet.

Answer: Step 1, list the absolute rupee figures for both years, as given above.

Step 2, take total assets (= total liabilities) as the common base of 100 for each year separately: ₹41,50,000 in 2016 and ₹32,50,000 in 2017.

Step 3, express every item as a percentage of its own year's base. On the liabilities side, share capital is 36.14% (2016) and 36.93% (2017); reserves and surplus 12.05% and 15.38%; long-term borrowings 14.46% and 15.38%; trade payables 37.35% and 32.31%.

On the assets side, plant and machinery is 33.73% and 24.62%; goodwill 38.55% and 36.92%; non-current investments 24.10% and 30.77%; inventories 3.62% and 7.69%. Each side totals exactly 100% in each year.

Draw two stacked bar columns, one for each year, each reaching 100% on the y-axis, with segments for tangible fixed assets, goodwill, non-current investments and inventories, so that the change in the structure of assets between the two years is visible even though the total (₹) has fallen.

How do you prepare a common size statement of profit and loss?

In the common size statement of profit and loss, every item of income and expenditure is shown as a percentage of the revenue from operations, which is taken as the base (100) for both years.

Common Size Percentage = Item ÷ Revenue × 100. Revenue from operations is set at 100 for each year, and every other item of income or expense is expressed as a percentage of it for that same year.

Worked example 4. Shefali Ltd., an Indian company, had the following figures: revenue from operations 2015-16 ₹25,00,000, 2016-17 ₹20,00,000; other income ₹3,25,000 and ₹2,50,000; employee benefit expenses ₹8,25,000 and ₹4,50,000; other expenses ₹2,00,000 and ₹1,00,000; income tax 30% of profit before tax in 2015-16 and 20% in 2016-17. Prepare the common size statement of profit and loss.

Answer: Step 1, take revenue from operations as the base of 100 in each year separately.

Step 2, express other income as a percentage of revenue: 13% (2015-16) and 12.5% (2016-17), giving total revenue of 113% and 112.5%.

Step 3, express the expenses as a percentage of revenue: employee benefit expenses are 33% and 22.5%; other expenses are 8% and 5%; profit before tax is therefore 72% and 85%.

Step 4, deduct tax (30% and 20% of profit before tax) to leave profit after tax at 50.4% (2015-16) and 68% (2016-17) of revenue from operations.

Worked example 5. Madhu Co. Ltd., an Indian company, had the following figures: revenue from operations 2015-16 ₹16,00,000, 2016-17 ₹20,00,000; employee benefit expenses ₹8,00,000 and ₹10,00,000; other expenses ₹2,00,000 and ₹1,00,000; tax rate 40% in both years. Prepare the common size statement of profit and loss.

Answer: Step 1, take revenue from operations as 100 in each year: ₹16,00,000 (2015-16) and ₹20,00,000 (2016-17).

Step 2, employee benefit expenses are 50% of revenue in both years (₹8,00,000 ÷ ₹16,00,000 and ₹10,00,000 ÷ ₹20,00,000).

Step 3, other expenses are 12.5% of revenue in 2015-16 (₹2,00,000 ÷ ₹16,00,000) and 5% in 2016-17 (₹1,00,000 ÷ ₹20,00,000), so profit before tax is 37.5% and 45% of revenue respectively.

Step 4, tax at 40% of profit before tax is 15% of revenue (2015-16) and 18% of revenue (2016-17), leaving profit after tax at 22.5% of revenue in 2015-16 and 27% of revenue in 2016-17, which shows that Madhu Co. Ltd. converted a larger share of its revenue into profit in the second year even though expenses fell as a proportion of a larger revenue base.

What are the overall limitations of financial statement analysis?

Though financial analysis is quite helpful in determining the financial strengths and weaknesses of a firm, it is based entirely on the information available in financial statements, and so it also suffers from various limitations of those statements.

An analyst must be conscious of the impact of price level changes, window dressing of financial statements, changes in accounting policies, accounting concepts and conventions, and personal judgement.

• Financial analysis does not consider price level changes (the effect of inflation on the figures over time).
• It may be misleading without knowledge of changes in the accounting procedure followed by a firm from one year to the next.
• It is just a study of the reports of the company, and depends on those reports being accurate and complete.
• Monetary information alone is considered in financial analysis, while non-monetary aspects (such as the quality of management or employee morale) are ignored.
• The financial statements are prepared on the basis of accounting concepts and conventions, so they do not necessarily reflect the current (market) position of assets and liabilities.

Going beyond the syllabus

Comparative statements, common size statements, trend analysis, ratio analysis and cash flow analysis are together the commonly used tools of financial statement analysis. This unit focuses on the first two, which are both ways of converting raw rupee figures into a form that can be compared across time or across firms.

Trend analysis extends the idea of a comparative statement over a longer run of years: it fixes one year as the base year (100) and expresses every later year's figure of the same item as a percentage of that base year figure, so that a student can see, at a glance, whether an item such as revenue or borrowings has been steadily rising, falling or staying roughly level over the series, rather than just between two years.

Ratio analysis and cash flow analysis are separate, more detailed tools that are usually studied on their own: ratio analysis studies relationships between individual items of the balance sheet and the statement of profit and loss (such as liquidity, solvency and profitability ratios), while cash flow analysis studies the actual movement of cash into and out of the firm during the year, which a comparative or common size statement, being based on accrual figures, does not show directly.

Glossary

• Financial statement analysis — critical evaluation of the financial information in financial statements to understand and make decisions about the firm's operations.
• Analysis — simplification of financial data by methodical classification given in the financial statements.
• Interpretation — explaining the meaning and significance of the simplified financial data.
• Comparative statements — statements showing figures of two or more periods side by side with the absolute and percentage change between them.
• Horizontal analysis — another name for comparative statement analysis, because figures are compared across a row of years.
• Common size statement — a statement where every item is expressed as a percentage of a common base such as total assets or revenue from operations.
• Vertical analysis — another name for common size statement analysis, because each figure is compared down a single period's column.
• Absolute change — the rupee increase or decrease in an item between two periods, found by subtraction.
• Percentage change — the absolute change expressed as a percentage of the first year's figure.
• Revenue from operations — the base figure used as 100% in a common size statement of profit and loss.
• Intra-firm comparison — comparing a firm's own figures across two or more accounting periods.
• Inter-firm comparison — comparing the figures of two or more different firms for the same period.
• Window dressing — presenting financial statements in a way that makes the firm's position look better than it actually is.
• Annual report — a document containing the balance sheet, statement of profit and loss, cash flow statement and management's discussion of the year's performance.

Common errors and misconceptions

• Misconception: The base for a comparative balance sheet is always the second year. Correct: The percentage change always uses the first year's figure as the base, in the denominator.
• Misconception: A common size statement of profit and loss uses total assets as the base. Correct: It uses revenue from operations as the base (100); total assets or total liabilities is the base only for a common size balance sheet.
• Misconception: Comparative statements and common size statements are the same thing. Correct: Comparative statements (horizontal analysis) compare absolute figures across periods; common size statements (vertical analysis) express each item as a percentage of a common base within one period.
• Misconception: A negative percentage change means an error in calculation. Correct: A negative figure, shown in brackets, correctly represents a decrease between the first year and the second year.
• Misconception: Common size statements can be prepared only for one firm. Correct: They are especially useful for inter-firm comparison, since percentages bring firms of different sizes to a common base.
• Misconception: Financial statement analysis removes the need for judgement. Correct: It remains a judgemental process; it estimates and predicts, and still depends on the reliability of the underlying financial statements.
• Misconception: Comparing statements prepared under different accounting principles is always valid as long as the periods are consecutive. Correct: Comparability requires the same accounting principles in both periods; any deviation should be disclosed by way of a footnote.

Exam-style questions with model answers

Q1. Choose the correct option. Comparative statement analysis is also known as: (a) vertical analysis (b) horizontal analysis (c) common size analysis (d) inter-firm analysis. [1 mark]

1. (b) horizontal analysis.

Q2. State the base used for (a) a common size balance sheet and (b) a common size statement of profit and loss. [2 marks]

1. (a) In a common size balance sheet, each item is expressed as a percentage of total assets, which equals total liabilities, taken as the common base (100).
2. (b) In a common size statement of profit and loss, each item of income and expenditure is expressed as a percentage of revenue from operations, taken as the base (100).

Q3. Madhu Co. Ltd.'s profit before tax was ₹6,00,000 in 2015-16 and ₹9,00,000 in 2016-17. Calculate the absolute change and percentage change in profit before tax, showing the formula used. [3 marks]

1. Absolute change = Second year − First year = ₹9,00,000 − ₹6,00,000 = ₹3,00,000 (an increase).
2. Percentage change = (Absolute change ÷ First year figure) × 100 = (₹3,00,000 ÷ ₹6,00,000) × 100 = 50%.
3. The profit before tax of Madhu Co. Ltd. therefore increased by ₹3,00,000, or 50%, between 2015-16 and 2016-17.

Q4. Distinguish between intra-firm comparison and inter-firm comparison, with one example each of what might be compared. [4 marks]

1. Intra-firm comparison compares a single firm's own figures across two or more accounting periods, for example comparing Amrit Limited's own balance sheet as at 31 March 2016 with its balance sheet as at 31 March 2017.
2. Inter-firm comparison compares the figures of two or more different firms for the same period, for example preparing a common size balance sheet for Aditya Ltd. and Anjali Ltd. for the same year.
3. Intra-firm comparison is mainly useful to study a firm's own trend and direction of growth over time.
4. Inter-firm comparison is mainly useful to judge a firm's relative performance against a competitor or against the industry as a whole, and is particularly aided by common size statements, which bring differently sized firms to a common percentage base.

Q5. From the following balance sheet of Amrit Limited as at 31 March 2016 and 2017, prepare a comparative balance sheet showing absolute change and percentage change: share capital ₹15,00,000 and ₹20,00,000; reserves and surplus ₹14,00,000 and ₹13,00,000; long-term borrowings ₹16,00,000 and ₹19,00,000; trade payables ₹2,00,000 and ₹3,00,000; tangible assets ₹15,00,000 and ₹20,00,000; intangible assets ₹16,00,000 and ₹19,00,000; inventories ₹14,00,000 and ₹13,00,000; cash and cash equivalents ₹2,00,000 and ₹3,00,000. [6 marks]

1. Share capital: 15 to 20 (₹ lakhs), an increase of 5, or 33.33%.
2. Reserves and surplus: 14 to 13, a decrease of 1, or 7.14%.
3. Long-term borrowings: 16 to 19, an increase of 3, or 18.75%.
4. Trade payables: 2 to 3, an increase of 1, or 50%.
5. Total equity and liabilities: 47 to 55, an increase of 8, or 17.02%.
6. Tangible assets: 15 to 20, an increase of 5, or 33.33%.
7. Intangible assets: 16 to 19, an increase of 3, or 18.75%.
8. Inventories: 14 to 13, a decrease of 1, or 7.14%.
9. Cash and cash equivalents: 2 to 3, an increase of 1, or 50%.
10. Total assets: 47 to 55, an increase of 8, or 17.02%, which matches the total on the equity and liabilities side, confirming the balance sheet is correctly balanced in both years.

Q6. From the following balance sheet of XRI Ltd. as at 31 March 2016 and 2017, prepare a common size balance sheet showing each item as a percentage of total assets: share capital ₹15,00,000 and ₹12,00,000; reserves and surplus ₹5,00,000 and ₹5,00,000; long-term borrowings ₹6,00,000 and ₹5,00,000; trade payables ₹15,50,000 and ₹10,50,000; plant and machinery ₹14,00,000 and ₹8,00,000; goodwill ₹16,00,000 and ₹12,00,000; non-current investments ₹10,00,000 each year; inventories ₹1,50,000 and ₹2,50,000; total ₹41,50,000 and ₹32,50,000. [6 marks]

1. Taking total assets (= total liabilities) as 100 in each year: share capital is 36.14% in 2016 and 36.93% in 2017.
2. Reserves and surplus are 12.05% and 15.38%.
3. Long-term borrowings are 14.46% and 15.38%.
4. Trade payables are 37.35% and 32.31%; the three liabilities items and share capital total 100% in each year.
5. Plant and machinery is 33.73% and 24.62%.
6. Goodwill is 38.55% and 36.92%.
7. Non-current investments are 24.10% and 30.77%.
8. Inventories are 3.62% and 7.69%; the four assets items total 100% in each year.
9. The common size figures show that, although the firm's total assets fell from ₹41,50,000 to ₹32,50,000, the proportion held in non-current investments and inventories actually rose, while the share held in plant and machinery fell.

Q7. State any three limitations of financial statement analysis. [3 marks]

1. Financial analysis does not consider price level changes, so it does not allow for the effect of inflation on figures recorded in different years.
2. It may be misleading without knowledge of changes in the accounting procedure followed by the firm, since a change in method can make figures look different even if the underlying business has not changed.
3. Monetary information alone is considered, while non-monetary aspects, such as the quality of management or employee morale, are ignored even though they affect the firm's real position.

Q8. State two objectives of financial statement analysis. [2 marks]

1. To assess the current profitability and operational efficiency of the firm as a whole, as well as of its different departments, so as to judge its financial health.
2. To judge the firm's ability to repay its debt by assessing both its short-term and long-term liquidity position.

Key takeaways

• Financial statement analysis is a judgemental process of analysis and interpretation of financial statements to assess profitability, efficiency and future prospects.
• Comparative statements (horizontal analysis) show absolute figures of two periods, the absolute change and the percentage change, using the first year as the base.
• Common size statements (vertical analysis) express each item as a percentage of a common base: total assets or total liabilities for the balance sheet, revenue from operations for the statement of profit and loss.
• Intra-firm comparison compares a firm's own figures over time; inter-firm comparison compares two or more different firms for the same period.
• Comparative statements require the same accounting principles in both periods, with any deviation disclosed as a footnote.
• The merit of common size statements is that they let analysts compare firms of very different sizes using percentages rather than absolute rupee figures.
• Financial analysis is useful to finance managers, top management, trade payables, lenders, investors, labour unions and government agencies, each with a different focus.
• Limitations of financial statement analysis include ignoring price level changes, dependence on consistent accounting procedure, and ignoring non-monetary aspects of the business.

Test yourself

What is another name for comparative statement analysis?

Horizontal analysis, because it compares figures across a row of two or more accounting periods.

What is another name for common size statement analysis?

Vertical analysis, because it compares each item down a single period's column as a percentage of a common base.

What base is used in a common size statement of profit and loss?

Revenue from operations is taken as the base, set at 100%, and every other item of income or expense is expressed as a percentage of it.

If share capital rises from ₹10,00,000 to ₹12,00,000, what is the percentage change?

Absolute change is ₹2,00,000; percentage change is (₹2,00,000 ÷ ₹10,00,000) × 100 = 20%.

Why must the same accounting principles be used in both years of a comparative statement?

Because the figures are comparable only if prepared on the same basis; any change in accounting principle should be disclosed as a footnote so the comparison is not misleading.

Name two types of users interested in a firm's financial statement analysis besides the finance manager.

Trade payables (interested in short-term liquidity) and long-term lenders (interested in solvency and ability to pay interest and repay principal).

Is financial statement analysis purely objective, or does it involve judgement?

It is a judgemental process: it involves estimating and predicting future conditions, and depends on the reliability of the underlying financial statements.

Give one limitation of financial statement analysis related to money.

Only monetary information is considered in financial analysis, so non-monetary aspects of the business, such as employee morale, are ignored even though they affect performance.