Analysis of Financial Statements

Written and reviewed by Devendra Dubey, Mathematics & Commerce faculty at UniDrill (M.Sc. Mathematics, Osmania University · 10 years teaching). Based on NCERT Accountancy Class XII (Accountancy Part II), Chapter 4.

Record sales, yet profit grew slower: is that good news?

A company announces that its revenue rose 25% this year. A shareholder, pleased, opens the accounts and finds that profit before tax rose only 20%. Something grew faster than sales and ate into the gain. The balance sheet and the Statement of Profit and Loss show the figures, but they do not say what changed or why it matters. Financial statement analysis is the set of tools that turns two columns of numbers into a story. This chapter gives you the tools, and the rules for using each one correctly.

What financial statement analysis is

Financial statement analysis is the critical evaluation of the figures in the balance sheet and the Statement of Profit and Loss, to understand a firm's profitability, operating efficiency, financial health and future prospects. It does two jobs that go together.

Analysis without interpretation is only a table, and interpretation without analysis has nothing to stand on. The two are complementary.

The analysis can be done in two directions.

Who uses it, and what they look for

Each user reads the same statements with a different question in mind. This matching is a favourite of CUET.

The objectives follow from this: to assess current profitability and operating efficiency, to see the relative importance of each component, to find the reasons for changes, and to judge short term and long term liquidity and the ability to repay debt.

The five tools

Ratio analysis and cash flow analysis have their own chapters. Here we develop the first three. A quick way to choose a tool is to ask what the question is about.

Comparative statements: measuring change

A comparative statement puts two (or more) years side by side. It has five columns: Particulars, first year, second year, absolute change, and percentage change. The percentage change always uses the first (earlier) year as the base, because we are asking "how much has this grown from where it started?"

$$\text{Absolute change} = \text{Second year} - \text{First year}$$

$$\text{Percentage change} = \dfrac{\text{Absolute change}}{\text{First year figure}} \times 100$$

For comparison to be fair, the same accounting principles must be used in both years. If they were not, the difference must be footnoted.

Worked example: comparative Statement of Profit and Loss. Kavya Traders Ltd. has the following figures. Prepare a comparative statement and say why profit grew slower than revenue.

Each percentage is the absolute change divided by the 2023-24 figure. For example, other expenses: 4,00,000 ÷ 6,00,000 × 100 = 66.67%. Interpretation: total revenue grew 25% but total expenses grew 27.27%, led by other expenses at 66.67%. That is why profit grew only 20%.

Common wrong step. Dividing by the second year. That gives 15,00,000 ÷ 75,00,000 = 20% for revenue, instead of 25%. The earlier year is always the base.

Worked example: comparative balance sheet. The same firm's balance sheet as at 31 March:

Both totals agree in each year, and the change in total equity and liabilities (₹1,50,000) equals the change in total assets. Interpretation: the firm repaid ₹2,00,000 of long-term loans using profits retained in reserves. Meanwhile inventories rose 30% and trade receivables 25%, but cash stayed the same, so more money is locked up in stock and credit sales. A fall in fixed assets (−5.56%) shows depreciation exceeding new purchases.

Common wrong step. Giving the percentage change in total assets as 5% (1,50,000 ÷ 30,00,000 by mistake) or writing the change in borrowings as +25% because "the number is 25". Keep the sign: a decrease is negative.

Pause and predict: revenue falls from ₹80 lakh to ₹60 lakh. What is the percentage change?

Check your answer: −25%. The change is −20 lakh and the base is the earlier year, 80 lakh. Using the later year (60 lakh) gives −33.33%, which is the common wrong answer.

Common size statements: measuring structure

A comparative statement tells you how much each item changed. A common size statement tells you how big each item is relative to a total. Every item is expressed as a percentage of a common base, which is set at 100. That lets you compare a ₹5-crore firm with a ₹500-crore firm, or the same firm across years, because the rupee sizes drop out.

$$\text{Common size percentage} = \dfrac{\text{Amount of the item}}{\text{Base}} \times 100$$

The format has four columns: Particulars, the amount for each year, and the percentage for each year.

Worked example: common size Statement of Profit and Loss. Prepare a common size statement from the following (there is no other income):

Check: in 2024-25, 24,00,000 ÷ 50,00,000 gives 48%, and 2,00,000 ÷ 50,00,000 gives 4%. Because every percentage is out of the same revenue, the expenses and the profit add back to 100 (84 + 16). Interpretation: materials took a smaller share (50% to 48%) and finance costs also fell (5% to 4%), but employee benefits and other expenses took more. The net effect: profit rose from 15% to 16% of revenue.

Common wrong step. Using total expenses or profit as the base. The base must be revenue from operations, so that every percentage is "per ₹100 of sales".

Worked example: common size balance sheet.

In 2024-25: 12,00,000 ÷ 36,00,000 = 33.33% and 7,00,000 ÷ 36,00,000 = 19.44%. Each side adds to 100%. Interpretation: the share of borrowings in funding fell from 30% to 25% although the rupee figure stayed at ₹9,00,000. Current liabilities grew from 10% to 16.67%, and inventories from 15% to 19.44%, so the firm is financing more of its stock through short term credit.

Pause and predict: in a common size balance sheet, borrowings fall from 30% to 25% of total funds. Did the company repay debt?

Check your answer: not necessarily. Above, borrowings stayed at ₹9,00,000 while total funds grew, so the share fell. A common size statement shows structure; you need the rupee figures to know what actually moved.

Trend analysis: one base year for the whole series

Comparative statements usually compare two years. Trend analysis follows a series of years. You choose one base year and set each item in that year to 100. Every later year is expressed as a percentage of the same item in the base year, never of the year before.

$$\text{Trend percentage} = \dfrac{\text{Amount in the given year}}{\text{Amount in the base year}} \times 100$$

Worked example: trend of sales and profit. Using 2020-21 as the base year:

For 2022-23: sales 27,00,000 ÷ 20,00,000 × 100 = 135 and profit 2,10,000 ÷ 2,00,000 × 100 = 105. Interpretation: sales rose every year, but profit dipped in 2022-23 (the index fell from 120 to 105) before recovering, so something in that year, such as costs or a one-time loss, needs investigating.

Common wrong step. Using the previous year as the base each time. That gives 120, 112.5, 111.11, 120, a chain of year-on-year growth rates, not a trend index. Trend percentages always divide by the base year, and the base year itself is 100, not the latest year.

Beyond the textbook. For the exam: trend analysis sets the base year at 100 and reads the series upward or downward. In reality: the choice of base year can change the story. If the base year was unusually bad, such as a year of lockdown, every later year looks spectacular. Analysts therefore choose a normal year, and a percentage on a very small base can also mislead: a rise from ₹10,000 to ₹50,000 is +400%, yet it is a small sum. Why it matters: in questions and in life, check the base before you trust the percentage.

From analysis to interpretation: reading the story

Each tool prompts a different kind of statement. Practise saying the interpretation in one sentence.

Limitations of financial analysis

An analyst must also watch for window dressing, which means presenting the statements more favourably than the true position, and for different accounting policies and personal judgement.

Beyond the textbook. For the exam: analysis ignores price level changes. In reality: when prices are rising, growth in rupees overstates real growth. If revenue rises 8% in a year when prices rose 6%, real growth is only about 2%. Why it matters: a "record" turnover may only be inflation, so compare growth with the rate of price change before praising it.

Exam traps

Formula sheet

60-second revision

Where this chapter connects

• Previous: Financial Statements of a Company gives the Schedule III heads whose figures you analyse here.
• Next: Accounting Ratios develops the fourth tool of analysis, comparing items within a year.
• Also: Cash Flow Statement develops the fifth tool, the analysis of cash movements.