Accountancy: Class 12 (Part 2) — Chapter 4: Analysis of Financial Statements

4.1 Meaning of Analysis of Financial Statements

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 is called Financial Statement Analysis. It is basically a study of relationship among various financial facts and figures as given in a set of financial statements, and the interpretation thereof to gain an insight into the profitability and operational efficiency of the firm to assess its financial health and future prospects.

The term financial analysis includes both analysis and interpretation:

Analysis: Simplification of financial data by methodical classification given in the financial statements.
Interpretation: 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.

4.2 Significance of Analysis of Financial Statements

Financial analysis is the process of identifying the financial strengths and weaknesses of the firm by properly establishing relationships between the various items of the balance sheet and the statement of profit and loss. It is useful and significant to different users in the following ways:

Key Users and Significance

Finance Manager: Focuses on facts and relationships related to managerial performance, corporate efficiency, financial strengths/weaknesses, and creditworthiness to make rational decisions.
Top Management: Interested in every aspect of financial analysis to ensure resources are used efficiently and the firm's financial condition is sound.
Trade Payables: Appraises the ability of the company to meet its short-term obligations and evaluates the firm's liquidity position.
Lenders: Concerned with long-term solvency and survival. They analyze profitability, cash generation ability, and capital structure relationships.
Investors: Concentrate on present and future profitability, capital structure, and risk to decide whether to buy, sell, or hold shares.
Labour Unions: Analyze statements to assess if the firm can afford wage increases or absorb them through productivity.
Others (Economists, Researchers, Government): Study business and economic conditions, price regulations, and taxation.

4.3 Objectives of Analysis of Financial Statements

The main objectives of financial analysis are:

To assess the current profitability and operational efficiency of the firm as a whole and its departments.
To ascertain the relative importance of different components of the financial position.
To identify the reasons for change in the profitability or financial position of the firm.
To judge the ability of the firm to repay its debt and assess short-term and long-term liquidity.

4.4 Tools of Analysis of Financial Statements

The most commonly used techniques of financial analysis are:

Comparative Statements: Statements showing the profitability and financial position of a firm for different periods of time in a comparative form. Also known as Horizontal Analysis.
Common Size Statements: Statements indicating the relationship of different items of a financial statement with a common item by expressing each item as a percentage of that common item. Also known as Vertical Analysis.
Trend Analysis: A technique of studying operational results and financial position over a series of years to observe percentage changes over time relative to a base year.
Ratio Analysis: Describes the significant relationship which exists between various items of a balance sheet and a statement of profit and loss.
Cash Flow Analysis: Refers to the analysis of actual movement of cash (inflows and outflows) into and out of an organization.

4.5 Comparative Statements

These statements provide columns for figures of both the current year and the previous year, showing absolute and relative changes. This helps identify the direction of changes and performance trends.

Steps to Prepare Comparative Statements

List absolute figures in rupees for two points of time (Columns 2 and 3).
Find the change in absolute figures by subtracting the first year from the second year (Column 4).
Calculate the percentage change (Column 5) using the formula:

$$\text{Percentage Change} = \frac{\text{Absolute Increase or Decrease (Col. 4)}}{\text{First Year Absolute Figure (Col. 2)}} \times 100$$

Format of Comparative Statement (Exhibit 4.1)

Particulars	First Year (Col. 2)	Second Year (Col. 3)	Absolute Increase (+) or Decrease (-) (Col. 4)	Percentage Increase (+) or Decrease (-) (Col. 5)
	Rs.	Rs.	Rs.	%

Illustration: Comparative Statement of Profit and Loss

Particulars	2015-16 (Rs.)	2016-17 (Rs.)	Absolute Increase/Decrease (Rs.)	Percentage Increase/Decrease (%)
I. Revenue from operations	60,00,000	75,00,000	15,00,000	25.00
II. Add: Other incomes	1,50,000	1,20,000	-30,000	-20.00
III. Total Revenue (I+II)	61,50,000	76,20,000	14,70,000	23.90
IV. Less: Expenses	44,00,000	50,60,000	6,60,000	15.00
Profit before tax	17,50,000	25,60,000	8,10,000	46.29
V. Less: Tax	6,12,500	10,24,000	4,11,500	67.18
Profit after tax	11,37,500	15,36,000	3,98,500	35.03

4.6 Common Size Statement

Also known as component percentage statements, this tool expresses each item as a percentage of a common base (e.g., total assets/liabilities for Balance Sheet, or revenue from operations for Statement of Profit and Loss).

Procedure for Preparation

List absolute figures for Year 1 and Year 2.
Choose a common base (100), such as Revenue from Operations or Total Assets.
For all items, calculate the percentage of that total base.

Illustration: Common Size Balance Sheet (XRI Co. Ltd.)

Particulars	Absolute Amounts (Rs.)		Percentage of Total Assets (%)
	31.03.2016	31.03.2017	31.03.2016	31.03.2017
I. Equity and Liabilities
1. Shareholders' fund	15,00,000	12,00,000	36.14	36.93
2. Non-current liabilities	6,00,000	5,00,000	14.46	15.38
3. Current liabilities	15,50,000	10,50,000	37.35	32.31
Total Liabilities	41,50,000	32,50,000	100.00	100.00
II. Assets
1. Non-current assets	30,00,000	20,00,000	72.28	61.54
2. Current assets	11,50,000	12,50,000	27.72	38.46
Total Assets	41,50,000	32,50,000	100.00	100.00

4.7 Limitations of Financial Analysis

Financial analysis is based on the information available in financial statements and suffers from the following limitations:

It does not consider price level changes.
It may be misleading without knowledge of changes in accounting procedures followed by a firm.
It is just a study of reports of the company (historical data).
Monetary information alone is considered; non-monetary qualitative aspects are ignored.
Financial statements are prepared on the basis of accounting concepts and conventions, which may not reflect the current market position.