Analysis of Financial Statements- 1 NCERT Solutions | Accountancy Class 12 - Commerce PDF Download

Short Answer Questions

Q1. List the techniques of Financial Statement Analysis.
Ans:

The following are the commonly used techniques of Financial Statement analysis:
1. Comparative Financial Statements - Compare figures of two or more periods side by side to identify changes in absolute and percentage terms.
2. Common Size Financial Statements - Express each item as a percentage of a common base (e.g., total assets or net sales) to study proportional relationships.
3. Trend Analysis - Show changes over a series of years using a base year to identify patterns and tendencies.
4. Ratio Analysis - Measure relationships between two or more items (for example, profitability, liquidity and solvency ratios) to assess performance.
5. Cash Flow Statement - Analyse the inflows and outflows of cash from operating, investing and financing activities.
6. Fund Flow Statement - Examine sources and applications of funds and changes in working capital.

The techniques can be classified based on the following criteria:

A. Comparison Basis

Inter-firm Comparison

• Comparative Statements (Balance Sheet, Profit and Loss Account)
• Common Size Statements (of the same period)
• Ratios of two or more competitive firms (of the same period)
• Cash Flow Statements of two or more competitive firms
• Graphs (Polygon, Bar Diagram)

Intra-firm Comparison

• Comparative Statements (Balance Sheet, Profit and Loss Account)
• Common Size Statements (of the same period)
• Ratios of two or more competitive firms (of the same period)
• Cash Flow Statements of two or more competitive firms
• Graphs (Polygon, Bar Diagram)
• Horizontal Comparison
• Vertical Comparison

B. Time Basis

Inter-period Comparison

• Comparative Statements (two or more periods)
• Cash Flow Statements (two or more periods)

Cross-Sectional (Intra-period) Comparison

• Common Size Statements
• Ratio Analysis

C. Horizontal Analysis

• Time Series
• Bar Diagrams
• Polygons
• Comparative Statements
• Ratio Analysis

D. Vertical Analysis

• Common Size Statements
• Pie Diagrams

Q2. Distinguish between Vertical and Horizontal Analysis of financial data.
Ans: 

Answer:

• Horizontal Analysis (Trend or Comparative Analysis): Compares financial data across two or more periods. It highlights absolute changes and percentage changes over time, helping to identify trends, growth rates and unusual fluctuations.
• Vertical Analysis (Common Size Analysis): Expresses each item in a financial statement as a percentage of a single base figure for the same period (for example, each profit and loss item as a percentage of net sales, or each balance sheet item as a percentage of total assets). It reveals the relative proportion of each item and facilitates comparisons between firms of different sizes for the same period.

Key difference: Horizontal analysis focuses on changes over time; vertical analysis focuses on the structure of a single period.

Q3. State the meaning of Analysis and Interpretation.
Ans: Analysis and Interpretation involve a systematic examination of financial statements. It aims to:

• Establish cause-and-effect relationships among various items.
• Present financial data clearly and understandably.
• Assist users in assessing the financial performance of a business over time.
• Support decision-making and policy formulation.

Country Man Ltd Comparative Statement as of March 31, 2010 and 2011

Interpretation:

• Sales increased by 50% in 2010-11 while cost of goods sold rose at a slower rate. This indicates an effective sales strategy or improved margins, resulting in an 80% increase in gross profit compared to the previous year.
• Operating expenses rose, but operating profit increased at a faster rate, showing improved operating efficiency and better control over overheads relative to sales growth.
• Profit before interest and tax rose by 115.38% over the two years, reflecting stronger overall operational performance and higher contribution from core activities.

Q4. State the importance of Financial Analysis.
Ans: Financial Analysis is crucial for various users as it provides insights into a business's financial health. By examining Income Statements, Balance Sheets, and other financial data, stakeholders can understand expenses, income sources and overall profitability. However, raw figures must be analysed to be useful. Tools such as Ratio Analysis and Cash Flow Statements help meet different users' needs. The significance of Financial Analysis can be summarised as follows:

• Evaluates Profitability: Assesses the firm's ability to generate profit and its earning capacity over time.
• Assesses Solvency: Determines the long-term ability of the business to meet its obligations.
• Comparative Analysis: Allows comparison of a firm's financial position with competitors and industry norms.
• Supports Decision-Making: Aids management in planning, decision-making and establishing effective internal controls.

Q5. What are Comparative Financial Statements?
Ans: Comparative Financial Statements are financial documents that enable comparison of figures either over different periods for the same company (intra-firm) or between different companies (inter-firm). They help users assess financial progress in relative terms. Key features include:

• Presentation of absolute figures, the change in these figures, and percentage changes over time.
• Clear layout that facilitates straightforward year-to-year comparisons.
• Meaningful comparisons require consistent application of the same accounting policies across the periods being compared.

Common types of Comparative Financial Statements include:

• Comparative Balance Sheet
• Comparative Income Statement

These statements are essential for identifying trends and changes in financial performance, thereby aiding improved decision-making.

Q6. What do you mean by Common Size Statements?
Ans: Common Size Statements present financial statement items as percentages of a chosen base figure, which makes comparisons easier and more meaningful. Key features include:

• Items in the Profit and Loss Statement are expressed as a percentage of Net Sales.
• Items in the Balance Sheet are shown as a percentage of Total Assets or Total Liabilities.
• This percentage format allows easy comparison across periods and between firms of different sizes within the same industry.

Common Size Statements are particularly useful for:

• Identifying trends when prepared for successive periods.
• Comparing companies of different absolute sizes by focusing on relative structure.

Common types of Common Size Statements include:

• Common Size Balance Sheet
• Common Size Income Statement

Overall, these statements give valuable insight into the financial structure and performance of a company.

Long Answer Questions

Q1: Describe the different techniques of financial analysis and explain the limitations of financial analysis.
Ans: The various techniques used in financial analysis are as follows:

1. Comparative Statements: These statements show figures of two or more accounting years side by side, enabling assessment of profitability and financial position over time. They present absolute changes and percentage changes, which help measure efficiency and reveal trends. Analyses based on these statements are commonly called Horizontal Analyses.
2. Common Size Statements: These express each item of financial statements as a percentage of a selected common figure (for example, net sales or total assets). This vertical presentation makes it easy to compare proportions across years and with other firms in the same industry.
3. Trend Analysis: This technique studies financial and operating trends over a series of years by choosing a base year and expressing other years as percentages of that base. Trend analysis helps detect upward or downward movements, assess operational efficiency and forecast likely future performance.
4. Ratio Analysis: Ratio analysis expresses relationships between two or more items (for example, current ratio, return on capital employed). It helps assess profitability, liquidity, operational efficiency and solvency. Ratios are easy to interpret and useful for comparison with industry standards or competitors.
5. Cash Flow Analysis: Cash flow analysis presents inflows and outflows of cash under operating, investing and financing activities for a period. It helps explain changes in cash balances and highlights the firm's ability to generate cash from operations.

Limitations of Financial Analysis
The limitations of Financial Analysis are:

1. Ignores Changes in Price Level
   Financial statements are usually prepared at historical cost and do not adjust for inflation. Thus, comparisons over long periods may be misleading.
2. Misleading or Wrong Information
   If accounting policies or classifications change between periods, comparisons may give a distorted picture unless adjustments are made.
3. Interim and Final Pictures
   Financial analysis is based on periodic reports and may not capture events occurring after the reporting date; it therefore provides a snapshot rather than a continuous picture.
4. Ignores Qualitative and Non-monetary Aspects
   Many important factors-such as management quality, market reputation and employee skill-are not reflected in monetary terms and so are omitted from these analyses.
5. Accounting Concepts and Conventions
   Analyses depend on accounting conventions (for example, historical cost, going concern). These conventions may not reflect current market values, so results should be interpreted with caution.
6. Involves Personal Bias
   Different choices in accounting estimates (depreciation methods, inventory valuation) can affect comparability and introduce bias.
7. Unsuitable for Direct Comparisons
   Because firms may follow different accounting policies or operate in different markets, direct comparisons can be unreliable unless adjustments are made.

Q2:  Explain the usefulness of trend percentages in the interpretation of the financial performance of a company.
Ans: The Trend Analysis presents each financial item in percentage terms for each year, using a base year for comparison. These trend percentages help users to assess the financial performance and to predict future tendencies. The usefulness of trend percentages includes:

1. Assists in Forecasting
   Trend percentages reveal consistent patterns that can be used to forecast future revenues, expenses and other financial items.
2. Percentage Terms
   Expressing figures as percentages simplifies analysis and comparison, making it easier to spot relative changes without handling large numbers.
3. User Friendly
   Trend percentages are easy to understand; they require no advanced accounting knowledge and are widely used by managers and external users alike.
4. Presents a Broader Picture
   Trend analysis over several years (commonly five to ten) presents a broad view of performance, making it easier to judge long-term improvements or declines than single-year comparisons.

Q3: What is the importance of comparative statements? Illustrate your answer with particular reference to comparative income statements.
Ans: The following are the importance of Comparative Statements.

1. Simple Presentation
   Comparative statements place year-wise figures side by side, making the presentation clear and enabling straightforward intra-firm and inter-firm comparisons.
2. Easy for Drawing Conclusions
   The side-by-side format allows an analyst to draw conclusions quickly about increases, decreases or stability in various financial items without ambiguity.
3. Easy to Forecast
   Comparative analysis of profitability and operational efficiency over several periods helps management to identify trends and plan future budgets and policies.
4. Easy Detection of Problems
   By comparing items across years, management can detect areas of concern (for example, rising expenses or falling margins) and take corrective action through budgetary control and other measures.

Q4:  What do you understand by analysis and interpretation of financial statements? Discuss their importance.
Ans: Financial analysis involves examining income statements, balance sheets and other financial data to evaluate a firm's performance and financial position. Interpretation means drawing meaningful conclusions from this analysis to inform decisions. The importance of financial analysis includes:

1. Helping to evaluate the profit-earning capacity and financial feasibility of the business.
2. Assessing long-term solvency and the ability to meet obligations.
3. Evaluating the relative financial status of a firm compared with competitors.
4. Assisting management in decision-making, planning and implementing effective control systems.

Q5: Explain how common size statements are prepared, giving an example.
Ans: The two Common Size Statements most commonly prepared are:

1. Common Size Balance Sheet
2. Common Size Income Statement

A Common Size Statement is prepared in columnar form. Each item is related to a common base and expressed as a percentage. This vertical approach is called Vertical Analysis. Typical columns are:

1. Particulars Column: Lists the various items under suitable headings.
2. Amount Columns: Show the rupee amounts for each item for the relevant year(s).
3. Percentage Columns: Show each item as a percentage of the chosen base (for example, total assets for balance sheet items or net sales for income statement items).

Common Size Statements can be presented in two ways:

Method 1
The Percentage Column is shown beside the Amount Column of the year to which the Percentage Column belongs.

Method 2
Amount Columns are shown first, followed by their Percentage Columns.

An example is provided below to illustrate the preparation of a Common Size Balance Sheet and Common Size Income Statement. Observe the images for numerical demonstration and layout.

Preparation

• Step 1: Write the title of the Common Size Statement at the top (for example, 'Common Size Balance Sheet').
• Step 2: In the 'Particulars' column, show the balance sheet items classified under 'Assets' and 'Equity and Liabilities'.
• Step 3: In the 'Amount' column, insert the monetary figures for the period under review.
• Step 4: Total the Assets and Liabilities separately for each year to ensure the statement balances.
• Step 5: In the 'Percentage' column, express each item as a percentage of the Total of the Balance Sheet (or net sales for the income statement).