Analysis of Financial Statements

2.1 Core concepts

Definition (§4.1, p. 171). Financial Statement Analysis is the process of critical evaluation of the financial information in the financial statements to understand and make decisions about the firm; it studies the relationship among various financial facts and figures to gain insight into profitability, operational efficiency, financial health and future prospects.

Analysis vs Interpretation (§4.1, p. 171-172). "Financial analysis" includes both analysis — simplification of financial data by methodical classification — and interpretation — explaining the meaning and significance of the data. The two are complementary: analysis is useless without interpretation, and interpretation without analysis is impossible.

Judgemental process (§4.1, p. 172). Financial statement analysis estimates current and past positions and operating results, with the primary objective of determining the best estimates and predictions about future conditions. It supports both cross-sectional analysis (comparison with other firms / industry) and time-series analysis (firm's own performance over time).

Significance — by user group (§4.2, p. 172-173). (a) Finance manager — rational decisions on operating policies, investment value, credit ratings, efficiency, and control through review of deviations. (b) Top management — ensures efficient resource use, measures success of operations, appraises individuals and evaluates internal control. (c) Trade payables — judge liquidity and ability to meet short-term and continued obligations. (d) Long-term lenders — assess long-term solvency, profitability, cash-generating ability and capital structure relationships. (e) Investors — focus on present and future profitability, capital structure, management efficiency; decide whether to buy, sell or hold shares. (f) Labour unions — assess whether the firm can afford or absorb a wage increase through productivity or price rises. (g) Others — economists and researchers study business and economic conditions; government uses analysis for price regulation, taxation, etc.

Objectives (§4.3, p. 173-174). Include assessing current profitability and operational efficiency, ascertaining the relative importance of components, identifying reasons for changes, judging ability to repay debt and assessing short-term and long-term liquidity.

Tools of financial analysis (§4.4, p. 174-175). (1) Comparative Statements — show profitability and financial position for different periods in comparative form; same accounting principles must be used else the deviation must be footnoted; also called "horizontal analysis". (2) Common Size Statements — express each item as a percentage of a common item, allowing comparison across years and across firms of different sizes; also called "vertical analysis" or "component percentage statements". (3) Trend Analysis — studies operational results and financial position over a series of years; trend percentage = each item of different years expressed as a percentage of the same item in the base year, which is set to 100. (4) Ratio Analysis — describes significant relationships between items of the balance sheet and statement of profit and loss, measuring profitability, solvency and efficiency (developed in leac205). (5) Cash Flow Analysis — tracks the actual movement of cash; net cash flow = inflow − outflow; cash flow statement summarises causes for change in cash position between two balance-sheet dates (developed in leac206).

Comparative Statements — preparation (§4.5, p. 176). Three steps: (i) list absolute figures for two periods, (ii) find absolute change (Year 2 − Year 1), (iii) compute percentage change = (Absolute change ÷ First-year figure) × 100. The format has five columns: Particulars, First Year, Second Year, Absolute Change (+/−), Percentage Change (+/−). NCERT's Illustration 1 (p. 177) demonstrates: BCR Co. Ltd. Revenue from operations rises ₹60,00,000 → ₹75,00,000, absolute change ₹15,00,000, percentage change 25%.

Common Size Statements — preparation (§4.6, p. 182-183). Choose a common base = 100. For the Statement of Profit and Loss the base is Revenue from operations; for the Balance Sheet the base is Total assets (or Total liabilities). Express every other item as a percentage of that base. The format has four columns: Particulars, Year 1 Amount, Year 2 Amount, Year 1 %, Year 2 %. NCERT's Illustration 5 (p. 183) shows COGS in 2015-16 = ₹12,00,000 ÷ ₹25,00,000 × 100 = 48%.

Trend Analysis (§4.4 ¶3, p. 175). Base year is taken as 100; each subsequent year's figure is expressed as a percentage of the same item in the base year. Useful for identifying long-run growth or decline patterns.

Limitations of financial analysis (§4.7, p. 187). (1) Ignores price-level changes (historical-cost data); (2) may mislead if changes in accounting procedure are not known; (3) is only a study of the company's reports; (4) considers only monetary information — non-monetary aspects are ignored; (5) statements are based on accounting concepts so they do not reflect the current position. The analyst must also be conscious of window-dressing, varying accounting policies, conventions and personal judgement.

2.2 Definitions to memorise

2.3 Diagrams / processes to remember

Exhibit 4.1 — Format of Comparative Statement (NCERT p. 176). Five columns — Particulars, First Year, Second Year, Absolute Change (+/−), Percentage Change (+/−).

Percentage-Change Formula (NCERT p. 176). (Absolute Increase or Decrease ÷ First-year absolute figure) × 100.

Illustration 1 — Comparative Statement of Profit and Loss (BCR Co. Ltd.) (NCERT p. 177). Revenue from operations rises ₹60,00,000 → ₹75,00,000, absolute change ₹15,00,000, percentage change 25%.

Illustration 3 — Comparative Balance Sheet (J. Ltd.) (NCERT p. 179). Total Equity & Liabilities rises ₹27 lakh → ₹35 lakh, absolute change ₹8 lakh, percentage change 29.63%.

Exhibit 4.2 — Format of Common Size Statement (NCERT p. 182). Four columns — Particulars, Year 1 Amount, Year 2 Amount, Year 1 %, Year 2 %.

Illustration 5 — Common Size Income Statement (NCERT p. 183). Revenue from operations = 100; COGS in 2015-16 = 12,00,000 ÷ 25,00,000 × 100 = 48%.

Illustration 7 — Common Size Balance Sheet (XRI Ltd.) (NCERT p. 185). Total Assets = 100; Share Capital 15,00,000 ÷ 41,50,000 × 100 = 36.14%.

Process — Comparative Statement preparation. (i) List items in column 1. (ii) Insert prior-year figures in column 2. (iii) Insert current-year figures in column 3. (iv) Compute absolute change in column 4. (v) Compute percentage change in column 5 using the first-year figure as denominator. (vi) Footnote any change in accounting policy.

Process — Common Size Statement preparation. (i) Identify the base — Revenue from operations (for P&L) or Total Assets/Liabilities (for Balance Sheet). (ii) Express every other item as (item ÷ base) × 100. (iii) Use four columns — two amounts and two percentages.

Process — Trend Analysis. (i) Select a base year. (ii) Set the base-year figure for each item to 100. (iii) For each subsequent year, express (Year i figure ÷ Base-year figure) × 100. (iv) Identify the trend — upward, downward, fluctuating.

2.4 Common confusions / NTA trap points

1. Horizontal vs Vertical. Comparative = horizontal; Common Size = vertical. Students often swap (NCERT §4.4 ¶1-2, p. 174).
2. Base in common-size P&L. Revenue from operations (not Total revenue or Net profit) (NCERT §4.6, p. 182).
3. Base in common-size Balance Sheet. Total assets / Total liabilities — not Capital (NCERT §4.6, p. 182).
4. Trend analysis base. Base year is 100 — not the latest year (NCERT §4.4 ¶3, p. 175).
5. Percentage change denominator. Uses the first (earlier) year as denominator, not the second year (NCERT §4.5, p. 176).
6. Limitations list. Includes price-level changes ignored, non-monetary info ignored — but does NOT include "ignores time value of money" or "ignores ratio analysis" (NCERT §4.7, p. 187).
7. Trade payables vs Long-term lenders. Trade payables → short-term liquidity; long-term lenders → long-term solvency (NCERT §4.2, p. 173).
8. Analysis ≠ Interpretation. Analysis = simplification + classification; Interpretation = explaining significance (NCERT §4.1, p. 171).
9. Common size vs comparative. Common size shows structure (each item as % of base); comparative shows change (absolute and % change over years) (NCERT §4.4, p. 174).
10. Investor vs labour union focus. Investor = profitability of shares; labour union = wage-increase affordability (NCERT §4.2, p. 173).
11. Trend analysis is for several years. Comparative statements typically two years; trend analysis many years (NCERT §4.4 ¶1, ¶3, p. 174-175).
12. Tools list has five. Comparative, Common Size, Trend, Ratio, Cash Flow — not six or four (NCERT §4.4, p. 174-175).

2.5 Journal entry templates

Analysis of Financial Statements is a presentation-and-comparison topic — it does not generate journal entries of its own. However, the tabular templates below show how a single data set is restated for analysis, alongside two illustrative entries common in adjacent topics.

(a) Comparative Statement of Profit and Loss — template (NCERT Exhibit 4.1, p. 176)

(b) Common Size Statement of Profit and Loss — template (NCERT Exhibit 4.2, p. 182)

(c) Trend Analysis — template (NCERT §4.4 ¶3, p. 175)

(d) Common Size Balance Sheet — template (NCERT Illus. 7, p. 185)

(e) Transfer of profit to reserves (illustrative journal entry behind the analysis above)

(f) Long-term borrowing taken (illustrative — Balance Sheet impact)

(g) Recording an exceptional item (would distort comparative analysis if not flagged)

(h) Window-dressing reversal — sale to related party (illustrative)