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171 Analysis of Financial Statements
Y
ou have learnt about the  financial statements
    (Income Statement and Balance Sheet) of
companies. Basically, these are summarised
financial reports which provide the operating results
and financial position of companies, and the detailed
information contained therein is useful for assessing
the operational efficiency and financial soundness
of a company. This requires proper analysis and
interpretation of such information for which a
number of techniques (tools) have been developed
by financial experts. In this chapter we will have an
overview of these techniques.
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’. The term 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
complimentary to each other. Analysis is useless
LEARNING OBJECTIVES
After studying this chapter,
you will be able to :
• explain the nature and
significance of financial
analysis;
• identify the objectives of
financial analysis;
• describe the various tools
of financial analysis;
• state the limitations of
financial analysis;
• prepare comparative and
common size statements
and interpret the data
given therein; and
•calculate the trend
percentages and interpret
them.
Analysis of Financial Statements 4
Rationalised 2023-24
Page 2


171 Analysis of Financial Statements
Y
ou have learnt about the  financial statements
    (Income Statement and Balance Sheet) of
companies. Basically, these are summarised
financial reports which provide the operating results
and financial position of companies, and the detailed
information contained therein is useful for assessing
the operational efficiency and financial soundness
of a company. This requires proper analysis and
interpretation of such information for which a
number of techniques (tools) have been developed
by financial experts. In this chapter we will have an
overview of these techniques.
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’. The term 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
complimentary to each other. Analysis is useless
LEARNING OBJECTIVES
After studying this chapter,
you will be able to :
• explain the nature and
significance of financial
analysis;
• identify the objectives of
financial analysis;
• describe the various tools
of financial analysis;
• state the limitations of
financial analysis;
• prepare comparative and
common size statements
and interpret the data
given therein; and
•calculate the trend
percentages and interpret
them.
Analysis of Financial Statements 4
Rationalised 2023-24
172 Accountancy : Company Accounts and Analysis of Financial Statements
without interpretation, and interpretation without analysis is difficult or even
impossible.
Financial statement analysis is a judgemental process which aims to estimate
current and past financial positions and the results of the operation of an
enterprise, with primary objective of determining the best possible estimates
and predictions about the future conditions. It essentially involves regrouping
and analysis of information provided by financial statements to establish
relationships and throw light on the points of strengths and weaknesses of a
business enterprise, which can be useful in decision-making involving comparison
with other firms (cross sectional analysis) and with firms’ own performance,
over a time period (time series analysis).
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. Financial analysis
can be undertaken by management of the firm, or by parties outside the firm,
viz., owners, trade creditors, lenders, investors, labour unions, analysts and
others. The nature of analysis will differ depending on the purpose of the analyst.
A technique frequently used by an analyst need not necessarily serve the purpose
of other analysts because of the difference in the interests of the analysts.
Financial analysis is useful and significant to different users in the following
ways:
(a) Finance manager: Financial analysis focusses on the facts and
relationships related to managerial performance, corporate efficiency,
financial strengths and weaknesses and creditworthiness of the company.
A finance manager must be well-equipped with the different tools of
analysis to make rational decisions for the firm. The tools for analysis
help in studying accounting data so as to determine the continuity of the
operating policies, investment value of the business, credit ratings and
testing the efficiency of operations. The techniques are equally important
in the area of financial control, enabling the finance manager to make
constant reviews of the actual financial operations of the firm to analyse
the causes of major deviations, which may help in corrective action
wherever indicated.
(b) Top management: The importance of financial analysis is not limited to
the finance manager alone. It has a broad scope which includes top
management in general and other functional managers. Management of
the firm would be interested in every aspect of the financial analysis. It is
their overall responsibility to see that the resources of the firm are
Rationalised 2023-24
Page 3


171 Analysis of Financial Statements
Y
ou have learnt about the  financial statements
    (Income Statement and Balance Sheet) of
companies. Basically, these are summarised
financial reports which provide the operating results
and financial position of companies, and the detailed
information contained therein is useful for assessing
the operational efficiency and financial soundness
of a company. This requires proper analysis and
interpretation of such information for which a
number of techniques (tools) have been developed
by financial experts. In this chapter we will have an
overview of these techniques.
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’. The term 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
complimentary to each other. Analysis is useless
LEARNING OBJECTIVES
After studying this chapter,
you will be able to :
• explain the nature and
significance of financial
analysis;
• identify the objectives of
financial analysis;
• describe the various tools
of financial analysis;
• state the limitations of
financial analysis;
• prepare comparative and
common size statements
and interpret the data
given therein; and
•calculate the trend
percentages and interpret
them.
Analysis of Financial Statements 4
Rationalised 2023-24
172 Accountancy : Company Accounts and Analysis of Financial Statements
without interpretation, and interpretation without analysis is difficult or even
impossible.
Financial statement analysis is a judgemental process which aims to estimate
current and past financial positions and the results of the operation of an
enterprise, with primary objective of determining the best possible estimates
and predictions about the future conditions. It essentially involves regrouping
and analysis of information provided by financial statements to establish
relationships and throw light on the points of strengths and weaknesses of a
business enterprise, which can be useful in decision-making involving comparison
with other firms (cross sectional analysis) and with firms’ own performance,
over a time period (time series analysis).
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. Financial analysis
can be undertaken by management of the firm, or by parties outside the firm,
viz., owners, trade creditors, lenders, investors, labour unions, analysts and
others. The nature of analysis will differ depending on the purpose of the analyst.
A technique frequently used by an analyst need not necessarily serve the purpose
of other analysts because of the difference in the interests of the analysts.
Financial analysis is useful and significant to different users in the following
ways:
(a) Finance manager: Financial analysis focusses on the facts and
relationships related to managerial performance, corporate efficiency,
financial strengths and weaknesses and creditworthiness of the company.
A finance manager must be well-equipped with the different tools of
analysis to make rational decisions for the firm. The tools for analysis
help in studying accounting data so as to determine the continuity of the
operating policies, investment value of the business, credit ratings and
testing the efficiency of operations. The techniques are equally important
in the area of financial control, enabling the finance manager to make
constant reviews of the actual financial operations of the firm to analyse
the causes of major deviations, which may help in corrective action
wherever indicated.
(b) Top management: The importance of financial analysis is not limited to
the finance manager alone. It has a broad scope which includes top
management in general and other functional managers. Management of
the firm would be interested in every aspect of the financial analysis. It is
their overall responsibility to see that the resources of the firm are
Rationalised 2023-24
173 Analysis of Financial Statements
used most efficiently and that the firm’s financial condition is sound.
Financial analysis helps the management in measuring the success of
the company’s operations, appraising the individual’s performance and
evaluating the system of internal control.
(c) Trade payables: Trade payables, through an analysis of financial
statements, appraises not only the ability of the company to meet its
short-term obligations, but also judges the probability of its continued
ability to meet all its financial obligations in future. Trade payables are
particularly interested in the firm’s ability to meet their claims over a
very short period of time. Their analysis will, therefore, evaluate the firm’s
liquidity position.
(d) Lenders: Suppliers of long-term debt are concerned with the firm’s long-
term solvency and survival. They analyse the firm’s profitability over a
period of time, its ability to generate cash, to be able to pay interest and
repay the principal and the relationship between various sources of funds
(capital structure relationships). Long-term lenders  analyse the historical
financial statements to assess its future solvency and profitability.
(e) Investors: Investors, who have invested their money in the firm’s shares,
are interested about the firm’s earnings. As such, they concentrate on
the analysis of the firm’s present and future profitability. They are also
interested in the firm’s capital structure to ascertain its influences on
firm’s earning and risk. They also evaluate the efficiency of the
management and determine whether a change is needed or not. However,
in some large companies, the shareholders’ interest is limited to decide
whether to buy, sell or hold the shares.
(f) Labour unions: Labour unions analyse the financial statements to assess
whether it can presently afford a wage increase and whether it can absorb
a wage increase through increased productivity or by raising the prices.
(g) Others: The economists, researchers, etc., analyse the financial statements
to study the present business and economic conditions. The government
agencies need it for price regulations, taxation and other similar purposes.
4.3 Objectives of Analysis of Financial Statements
Analysis of financial statements reveals important facts concerning
managerial performance and the efficiency of the firm. Broadly speaking,
the objectives of the analysis are to apprehend the information contained
in financial statements with a view to know the weaknesses and strengths
of the firm and to make a forecast about the future prospects of the firm
thereby, enabling the analysts to take decisions regarding the operation of,
Rationalised 2023-24
Page 4


171 Analysis of Financial Statements
Y
ou have learnt about the  financial statements
    (Income Statement and Balance Sheet) of
companies. Basically, these are summarised
financial reports which provide the operating results
and financial position of companies, and the detailed
information contained therein is useful for assessing
the operational efficiency and financial soundness
of a company. This requires proper analysis and
interpretation of such information for which a
number of techniques (tools) have been developed
by financial experts. In this chapter we will have an
overview of these techniques.
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’. The term 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
complimentary to each other. Analysis is useless
LEARNING OBJECTIVES
After studying this chapter,
you will be able to :
• explain the nature and
significance of financial
analysis;
• identify the objectives of
financial analysis;
• describe the various tools
of financial analysis;
• state the limitations of
financial analysis;
• prepare comparative and
common size statements
and interpret the data
given therein; and
•calculate the trend
percentages and interpret
them.
Analysis of Financial Statements 4
Rationalised 2023-24
172 Accountancy : Company Accounts and Analysis of Financial Statements
without interpretation, and interpretation without analysis is difficult or even
impossible.
Financial statement analysis is a judgemental process which aims to estimate
current and past financial positions and the results of the operation of an
enterprise, with primary objective of determining the best possible estimates
and predictions about the future conditions. It essentially involves regrouping
and analysis of information provided by financial statements to establish
relationships and throw light on the points of strengths and weaknesses of a
business enterprise, which can be useful in decision-making involving comparison
with other firms (cross sectional analysis) and with firms’ own performance,
over a time period (time series analysis).
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. Financial analysis
can be undertaken by management of the firm, or by parties outside the firm,
viz., owners, trade creditors, lenders, investors, labour unions, analysts and
others. The nature of analysis will differ depending on the purpose of the analyst.
A technique frequently used by an analyst need not necessarily serve the purpose
of other analysts because of the difference in the interests of the analysts.
Financial analysis is useful and significant to different users in the following
ways:
(a) Finance manager: Financial analysis focusses on the facts and
relationships related to managerial performance, corporate efficiency,
financial strengths and weaknesses and creditworthiness of the company.
A finance manager must be well-equipped with the different tools of
analysis to make rational decisions for the firm. The tools for analysis
help in studying accounting data so as to determine the continuity of the
operating policies, investment value of the business, credit ratings and
testing the efficiency of operations. The techniques are equally important
in the area of financial control, enabling the finance manager to make
constant reviews of the actual financial operations of the firm to analyse
the causes of major deviations, which may help in corrective action
wherever indicated.
(b) Top management: The importance of financial analysis is not limited to
the finance manager alone. It has a broad scope which includes top
management in general and other functional managers. Management of
the firm would be interested in every aspect of the financial analysis. It is
their overall responsibility to see that the resources of the firm are
Rationalised 2023-24
173 Analysis of Financial Statements
used most efficiently and that the firm’s financial condition is sound.
Financial analysis helps the management in measuring the success of
the company’s operations, appraising the individual’s performance and
evaluating the system of internal control.
(c) Trade payables: Trade payables, through an analysis of financial
statements, appraises not only the ability of the company to meet its
short-term obligations, but also judges the probability of its continued
ability to meet all its financial obligations in future. Trade payables are
particularly interested in the firm’s ability to meet their claims over a
very short period of time. Their analysis will, therefore, evaluate the firm’s
liquidity position.
(d) Lenders: Suppliers of long-term debt are concerned with the firm’s long-
term solvency and survival. They analyse the firm’s profitability over a
period of time, its ability to generate cash, to be able to pay interest and
repay the principal and the relationship between various sources of funds
(capital structure relationships). Long-term lenders  analyse the historical
financial statements to assess its future solvency and profitability.
(e) Investors: Investors, who have invested their money in the firm’s shares,
are interested about the firm’s earnings. As such, they concentrate on
the analysis of the firm’s present and future profitability. They are also
interested in the firm’s capital structure to ascertain its influences on
firm’s earning and risk. They also evaluate the efficiency of the
management and determine whether a change is needed or not. However,
in some large companies, the shareholders’ interest is limited to decide
whether to buy, sell or hold the shares.
(f) Labour unions: Labour unions analyse the financial statements to assess
whether it can presently afford a wage increase and whether it can absorb
a wage increase through increased productivity or by raising the prices.
(g) Others: The economists, researchers, etc., analyse the financial statements
to study the present business and economic conditions. The government
agencies need it for price regulations, taxation and other similar purposes.
4.3 Objectives of Analysis of Financial Statements
Analysis of financial statements reveals important facts concerning
managerial performance and the efficiency of the firm. Broadly speaking,
the objectives of the analysis are to apprehend the information contained
in financial statements with a view to know the weaknesses and strengths
of the firm and to make a forecast about the future prospects of the firm
thereby, enabling the analysts to take decisions regarding the operation of,
Rationalised 2023-24
174 Accountancy : Company Accounts and Analysis of Financial Statements
and further investment in the firm. To be more specific, the analysis is
undertaken to serve the following purposes (objectives):
• to assess the current profitability and operational efficiency of the
firm as a whole as well as its different departments so as to judge
the financial health of the firm.
• to ascertain the relative importance of different components of the
financial position of the firm.
• to identify the reasons for change in the profitability/financial position
of the firm.
• to judge the ability of the firm to repay its debt and assessing the
short-term as well as the long-term liquidity position of the firm.
Through the analysis of financial statements of various firms, an economist can
judge the extent of concentration of economic power and pitfalls in the financial
policies pursued. The analysis also provides the basis for many governmental
actions relating to licensing, controls, fixing of prices, ceiling on profits, dividend
freeze, tax subsidy and other concessions to the corporate sector.
4.4 Tools of Analysis of Financial Statements
The most commonly used techniques of financial analysis are as follows:
1. Comparative Statements: These 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 of two or more periods.
It usually applies to the two important financial statements, namely,
balance sheet and statement of profit and loss prepared in a comparative
form. The financial data will be comparative only when same accounting
principles are used in preparing these statements. If this is not the case,
the deviation in the use of accounting principles should be mentioned as
a footnote. Comparative figures indicate the trend and direction of financial
position and operating results. This analysis is also known as ‘horizontal
analysis’.
2. Common Size Statements: These are the statements which indicate the
relationship of different items of a financial statement with a common item
by expressing each item as a percentage of that common item. The
percentage thus calculated can be easily compared with the results of
corresponding percentages of the previous year or of some other firms, as
the numbers are brought to common base. Such statements also allow an
analyst to compare the operating and financing characteristics of two
companies of different sizes in the same industry. Thus, common size
statements are useful, both, in intra-firm comparisons over different years
and also in making inter-firm comparisons for the same year or for several
years. This analysis is also known as ‘Vertical analysis’.
Rationalised 2023-24
Page 5


171 Analysis of Financial Statements
Y
ou have learnt about the  financial statements
    (Income Statement and Balance Sheet) of
companies. Basically, these are summarised
financial reports which provide the operating results
and financial position of companies, and the detailed
information contained therein is useful for assessing
the operational efficiency and financial soundness
of a company. This requires proper analysis and
interpretation of such information for which a
number of techniques (tools) have been developed
by financial experts. In this chapter we will have an
overview of these techniques.
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’. The term 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
complimentary to each other. Analysis is useless
LEARNING OBJECTIVES
After studying this chapter,
you will be able to :
• explain the nature and
significance of financial
analysis;
• identify the objectives of
financial analysis;
• describe the various tools
of financial analysis;
• state the limitations of
financial analysis;
• prepare comparative and
common size statements
and interpret the data
given therein; and
•calculate the trend
percentages and interpret
them.
Analysis of Financial Statements 4
Rationalised 2023-24
172 Accountancy : Company Accounts and Analysis of Financial Statements
without interpretation, and interpretation without analysis is difficult or even
impossible.
Financial statement analysis is a judgemental process which aims to estimate
current and past financial positions and the results of the operation of an
enterprise, with primary objective of determining the best possible estimates
and predictions about the future conditions. It essentially involves regrouping
and analysis of information provided by financial statements to establish
relationships and throw light on the points of strengths and weaknesses of a
business enterprise, which can be useful in decision-making involving comparison
with other firms (cross sectional analysis) and with firms’ own performance,
over a time period (time series analysis).
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. Financial analysis
can be undertaken by management of the firm, or by parties outside the firm,
viz., owners, trade creditors, lenders, investors, labour unions, analysts and
others. The nature of analysis will differ depending on the purpose of the analyst.
A technique frequently used by an analyst need not necessarily serve the purpose
of other analysts because of the difference in the interests of the analysts.
Financial analysis is useful and significant to different users in the following
ways:
(a) Finance manager: Financial analysis focusses on the facts and
relationships related to managerial performance, corporate efficiency,
financial strengths and weaknesses and creditworthiness of the company.
A finance manager must be well-equipped with the different tools of
analysis to make rational decisions for the firm. The tools for analysis
help in studying accounting data so as to determine the continuity of the
operating policies, investment value of the business, credit ratings and
testing the efficiency of operations. The techniques are equally important
in the area of financial control, enabling the finance manager to make
constant reviews of the actual financial operations of the firm to analyse
the causes of major deviations, which may help in corrective action
wherever indicated.
(b) Top management: The importance of financial analysis is not limited to
the finance manager alone. It has a broad scope which includes top
management in general and other functional managers. Management of
the firm would be interested in every aspect of the financial analysis. It is
their overall responsibility to see that the resources of the firm are
Rationalised 2023-24
173 Analysis of Financial Statements
used most efficiently and that the firm’s financial condition is sound.
Financial analysis helps the management in measuring the success of
the company’s operations, appraising the individual’s performance and
evaluating the system of internal control.
(c) Trade payables: Trade payables, through an analysis of financial
statements, appraises not only the ability of the company to meet its
short-term obligations, but also judges the probability of its continued
ability to meet all its financial obligations in future. Trade payables are
particularly interested in the firm’s ability to meet their claims over a
very short period of time. Their analysis will, therefore, evaluate the firm’s
liquidity position.
(d) Lenders: Suppliers of long-term debt are concerned with the firm’s long-
term solvency and survival. They analyse the firm’s profitability over a
period of time, its ability to generate cash, to be able to pay interest and
repay the principal and the relationship between various sources of funds
(capital structure relationships). Long-term lenders  analyse the historical
financial statements to assess its future solvency and profitability.
(e) Investors: Investors, who have invested their money in the firm’s shares,
are interested about the firm’s earnings. As such, they concentrate on
the analysis of the firm’s present and future profitability. They are also
interested in the firm’s capital structure to ascertain its influences on
firm’s earning and risk. They also evaluate the efficiency of the
management and determine whether a change is needed or not. However,
in some large companies, the shareholders’ interest is limited to decide
whether to buy, sell or hold the shares.
(f) Labour unions: Labour unions analyse the financial statements to assess
whether it can presently afford a wage increase and whether it can absorb
a wage increase through increased productivity or by raising the prices.
(g) Others: The economists, researchers, etc., analyse the financial statements
to study the present business and economic conditions. The government
agencies need it for price regulations, taxation and other similar purposes.
4.3 Objectives of Analysis of Financial Statements
Analysis of financial statements reveals important facts concerning
managerial performance and the efficiency of the firm. Broadly speaking,
the objectives of the analysis are to apprehend the information contained
in financial statements with a view to know the weaknesses and strengths
of the firm and to make a forecast about the future prospects of the firm
thereby, enabling the analysts to take decisions regarding the operation of,
Rationalised 2023-24
174 Accountancy : Company Accounts and Analysis of Financial Statements
and further investment in the firm. To be more specific, the analysis is
undertaken to serve the following purposes (objectives):
• to assess the current profitability and operational efficiency of the
firm as a whole as well as its different departments so as to judge
the financial health of the firm.
• to ascertain the relative importance of different components of the
financial position of the firm.
• to identify the reasons for change in the profitability/financial position
of the firm.
• to judge the ability of the firm to repay its debt and assessing the
short-term as well as the long-term liquidity position of the firm.
Through the analysis of financial statements of various firms, an economist can
judge the extent of concentration of economic power and pitfalls in the financial
policies pursued. The analysis also provides the basis for many governmental
actions relating to licensing, controls, fixing of prices, ceiling on profits, dividend
freeze, tax subsidy and other concessions to the corporate sector.
4.4 Tools of Analysis of Financial Statements
The most commonly used techniques of financial analysis are as follows:
1. Comparative Statements: These 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 of two or more periods.
It usually applies to the two important financial statements, namely,
balance sheet and statement of profit and loss prepared in a comparative
form. The financial data will be comparative only when same accounting
principles are used in preparing these statements. If this is not the case,
the deviation in the use of accounting principles should be mentioned as
a footnote. Comparative figures indicate the trend and direction of financial
position and operating results. This analysis is also known as ‘horizontal
analysis’.
2. Common Size Statements: These are the statements which indicate the
relationship of different items of a financial statement with a common item
by expressing each item as a percentage of that common item. The
percentage thus calculated can be easily compared with the results of
corresponding percentages of the previous year or of some other firms, as
the numbers are brought to common base. Such statements also allow an
analyst to compare the operating and financing characteristics of two
companies of different sizes in the same industry. Thus, common size
statements are useful, both, in intra-firm comparisons over different years
and also in making inter-firm comparisons for the same year or for several
years. This analysis is also known as ‘Vertical analysis’.
Rationalised 2023-24
175 Analysis of Financial Statements
3. Trend Analysis: It is a technique of studying the operational results and
financial position over a series of years. Using the previous years’ data of a
business enterprise, trend analysis can be done to observe the percentage
changes over time in the selected data. The trend percentage is the
percentage relationship, in which each item of different years bear to the
same item in the base year. Trend analysis is important because, with its
long run view, it may point to basic changes in the nature of the business.
By looking at a trend in a particular ratio, one may find whether the ratio
is falling, rising or remaining relatively constant. From this observation, a
problem is detected or the sign of good or poor management is detected.
4. Ratio Analysis: It describes the significant relationship which exists
between various items of a balance sheet and a statement of profit and
loss of a firm. As a technique of financial analysis, accounting ratios measure
the comparative significance of the individual items of the income and
position statements. It is possible to assess the profitability, solvency and
efficiency of an enterprise through the technique of ratio analysis.
5. Cash Flow Analysis: It refers to the analysis of actual movement of cash
into and out of an organisation. The flow of cash into the business is called
as cash inflow or positive cash flow and the flow of cash out of the firm is
called as cash outflow or a negative cash flow. The difference between the
inflow and outflow of cash is the net cash flow. Cash flow statement is
prepared to project the manner in which the cash has been received and
has been utilised during an accounting year as it shows the sources of
cash receipts and also the purposes for which payments are made. Thus,
it summarises the causes for the changes in cash position of a business
enterprise between dates of two balance sheets.
In this chapter, we shall have a brief idea about the first three techniques,
viz., comparative statements, common size statements and trend analysis. The
ratio analysis and cash flow analysis is covered in detail in Chapters 5 and 6
respectively.
Test your Understanding – I
Fill in the blanks with appropriate word(s):
1. Analysis simply means—————data.
2. Interpretation means —————data.
3. Comparative analysis is also known as ———————— analysis.
4. Common size analysis is also known as ———————— analysis.
5. The analysis of actual movement of money inflow and outflow in an
organisation is called——————— analysis.
Rationalised 2023-24
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FAQs on NCERT Textbook - Analysis of Financial Statements - Accountancy Class 12 - Commerce

1. What is the purpose of analyzing financial statements?
Ans. The purpose of analyzing financial statements is to gain insights into the financial health and performance of a company. It helps in evaluating the profitability, liquidity, solvency, and efficiency of a business. By analyzing financial statements, stakeholders can make informed decisions regarding investments, credit lending, and business strategies.
2. What are the different methods used for analyzing financial statements?
Ans. There are several methods used for analyzing financial statements, including: - Ratio analysis: This method involves calculating various financial ratios, such as profitability ratios (e.g., gross profit margin, return on equity), liquidity ratios (e.g., current ratio, quick ratio), and solvency ratios (e.g., debt-to-equity ratio, interest coverage ratio). These ratios provide insights into the company's financial performance and position. - Vertical analysis: This method involves comparing different items within a financial statement to a base figure, usually expressed as a percentage. It helps in understanding the composition and relative importance of various components in the financial statements. - Horizontal analysis: Also known as trend analysis, this method involves comparing financial data over multiple periods to identify patterns and trends. It helps in assessing the company's performance and growth over time. - Cash flow analysis: This method focuses on analyzing the cash inflows and outflows of a company. It helps in evaluating the company's ability to generate cash and meet its short-term and long-term obligations.
3. How can financial statement analysis help in decision-making for investors?
Ans. Financial statement analysis plays a crucial role in the decision-making process for investors. It provides them with valuable information to assess the financial health and performance of a company before making investment decisions. By analyzing financial statements, investors can: - Evaluate the profitability and growth potential of a company: Financial ratios and trend analysis can help investors assess the profitability and growth prospects of a company. This information enables them to make informed decisions about whether to invest in the company's stocks or bonds. - Assess the risk associated with the investment: Financial statement analysis helps investors evaluate the company's liquidity and solvency position. This assists them in understanding the level of risk associated with the investment and determining the company's ability to meet its financial obligations. - Compare investment opportunities: By analyzing the financial statements of different companies, investors can compare their financial performance and make informed decisions about which company offers better investment opportunities.
4. What are the limitations of financial statement analysis?
Ans. Financial statement analysis has certain limitations, including: - Historical data: Financial statements are based on historical data, which may not reflect the current or future performance of a company. External factors, market conditions, and industry trends can significantly impact a company's financial position, which may not be captured in the financial statements. - Subjectivity: Financial statement analysis involves interpretation and judgment, which can be subjective. Different analysts may interpret the same financial information differently, leading to varying conclusions and recommendations. - Lack of comparability: Financial statements of different companies may not be directly comparable due to variations in accounting policies, estimates, and judgments. This can make it challenging to compare the financial performance of different companies accurately. - Limited focus: Financial statement analysis primarily focuses on quantitative data, such as numbers and ratios. It may not capture qualitative factors, such as management quality, brand value, and customer satisfaction, which can also impact a company's performance.
5. How can financial statement analysis help in assessing the creditworthiness of a company?
Ans. Financial statement analysis is essential for assessing the creditworthiness of a company before extending credit or loans. It helps lenders in evaluating the company's ability to repay the borrowed funds. By analyzing financial statements, lenders can: - Assess the company's liquidity position: Liquidity ratios, such as the current ratio and quick ratio, help lenders determine the company's ability to meet its short-term financial obligations. A higher liquidity ratio indicates a better ability to repay debt. - Evaluate the company's solvency: Solvency ratios, such as the debt-to-equity ratio and interest coverage ratio, provide insights into the company's long-term financial stability and its ability to service its debt obligations. Lower solvency ratios may indicate a higher risk of default. - Analyze the company's profitability: Profitability ratios, such as gross profit margin and net profit margin, help lenders assess the company's ability to generate profits. A higher profitability ratio indicates better financial health and a higher likelihood of loan repayment. - Consider the company's cash flow: Cash flow analysis helps lenders evaluate the company's ability to generate sufficient cash to meet its debt obligations. Positive cash flow indicates a better ability to repay loans. Overall, financial statement analysis provides lenders with a comprehensive understanding of the company's financial position, enabling them to make informed decisions regarding creditworthiness.
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