Analysis of Financial Statements

Meaning of Analysis of Financial Statements

**Financial Statement Analysis** is the process of critical evaluation of financial information contained in financial statements to understand and make decisions regarding the operations of a firm. It is essentially a study of relationships among various financial facts and figures to gain insight into the profitability, operational efficiency, financial health, and future prospects of an enterprise.

The term includes two complementary components:

**Analysis**: Simplification of financial data by methodical classification given in financial statements

**Interpretation**: Explaining the meaning and significance of the data

Analysis without interpretation is useless; interpretation without analysis is difficult or impossible. Together, they establish relationships and highlight strengths and weaknesses of a business.

**Two types of analysis** are fundamental:

**Time Series Analysis**: Comparing a firm's own performance over different time periods (past vs. present)

**Cross-Sectional Analysis**: Comparing one firm's performance with other firms in the same industry or segment

The analysis is a judgemental process aimed at estimating current and past financial positions and results of operations, with the primary objective of making best possible estimates and predictions about future conditions.

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Significance of Analysis of Financial Statements

Financial analysis identifies financial strengths and weaknesses by establishing relationships between balance sheet items and statement of profit and loss items. Different users have different interests; therefore, the nature of analysis differs depending on the analyst's purpose.

**Users of Financial Analysis and their Interests:**

**Finance Manager**: Uses analysis to focus on managerial performance, corporate efficiency, financial strengths/weaknesses, and creditworthiness. Tools help study accounting data to determine continuity of operating policies, investment value, credit ratings, and operational efficiency. Analysis also enables financial control through constant reviews of actual financial operations and identification of major deviations for corrective action.

**Top Management**: Has broad responsibility for ensuring efficient use of resources and sound financial condition. Analysis helps measure operational success, appraise individual performance, and evaluate internal control systems across all functional areas.

**Trade Payables/Creditors**: Appraise the company's ability to meet short-term obligations and continued ability to meet all financial obligations in future. Particularly interested in liquidity position and short-term payment capacity.

**Long-term Lenders/Suppliers of Debt**: Concerned with firm's long-term solvency and survival. Analyse profitability over time, cash generation ability, capacity to pay interest and principal, and capital structure relationships. Historical financial statements are analysed to assess future solvency.

**Investors/Shareholders**: Interested in firm's present and future earnings and profitability. Also evaluate capital structure's influence on earnings and risk, management efficiency, and whether to buy, sell, or hold shares.

**Labour Unions**: Analyse statements to assess whether firm can afford wage increases and whether it can absorb increases through productivity gains or price rises.

**Others**: Economists and researchers study present business and economic conditions. Government agencies use analysis for price regulations, taxation, and regulatory purposes.

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Objectives of Analysis of Financial Statements

Financial statement analysis serves specific purposes to help analysts understand weaknesses and strengths and forecast future prospects:

**Assess Current Profitability and Operational Efficiency**: Evaluate the firm as a whole and its different departments to judge overall financial health

**Determine Relative Importance**: Ascertain the relative significance of different components of the firm's financial position

**Identify Reasons for Changes**: Identify causes of changes in profitability and financial position over time periods

**Judge Debt Repayment Ability**: Assess the firm's capacity to repay debt and evaluate short-term as well as long-term liquidity positions

**Economic Analysis**: Through comparative analysis of various firms, economists judge the extent of concentration of economic power and identify pitfalls in financial policies

**Government Decisions**: Provide basis for governmental actions regarding licensing, controls, price fixing, profit ceilings, dividend freezes, tax subsidies, and corporate concessions

These objectives collectively enable decision-makers to evaluate whether to invest, lend, work with, or regulate a company.

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Tools of Analysis of Financial Statements

Five major techniques are used for financial statement analysis:

1. **Comparative Statements (Horizontal Analysis)**

These statements show profitability and financial position for different periods in comparative form, typically comparing two or more years side by side.

**Key Characteristics**:

Apply to balance sheet and statement of profit and loss

Use same accounting principles across periods (if not, disclose in footnotes)

Show trend and direction of financial position and operating results

Also called **Horizontal Analysis**

**Steps to Prepare**:

**Step 1**: List absolute figures in rupees for two points of time (columns for Year 1 and Year 2)

**Step 2**: Find absolute change by subtracting earlier year from later year (Year 2 - Year 1), indicating as increase (+) or decrease (–)

**Step 3**: Calculate percentage change using formula:

**Percentage Change = (Absolute Change ÷ First Year Figure) × 100**

**Format Example**:

| Particulars | Year 1 (Rs.) | Year 2 (Rs.) | Absolute Change (Rs.) | Percentage Change (%) |

|---|---|---|---|---|

| Revenue | 60,00,000 | 75,00,000 | 15,00,000 | 25.00 |

2. **Common Size Statements (Vertical Analysis)**

These statements express each item as a percentage of a common item, bringing all figures to a common base for easy comparison.

**Key Characteristics**:

Each item expressed as percentage of a base item (typically total revenue for P&L, or total assets/total liabilities for balance sheet)

Enable **intra-firm comparison** over different years

Enable **inter-firm comparison** for companies of different sizes in same industry

Also called **Vertical Analysis**

Useful for identifying changes in composition and structure

**For Income Statement**: Each item expressed as percentage of Net Revenue or Revenue from Operations

**For Balance Sheet**: Each item expressed as percentage of Total Assets or Total Liabilities

**Interpretation**: Shows what proportion each item represents of the whole, making structural changes visible.

3. **Trend Analysis**

Technique of studying operational results and financial position over a series of years, showing how items change over time.

**Key Concepts**:

Uses previous years' data to observe percentage changes over time

**Trend Percentage**: The percentage relationship that each item of different years bears to the same item in the **base year** (usually the earliest year)

**Formula**: (Item Value in Year / Item Value in Base Year) × 100

Shows whether a ratio/item is falling, rising, or remaining constant

Points to basic changes in business nature

Helps detect problems or signs of good/poor management

**Example**: If revenue in base year (Year 1) = Rs. 100, and Year 2 = Rs. 125, then Year 2 trend = 125% of base year.

4. **Ratio Analysis**

Describes significant relationships between various items of balance sheet and statement of profit and loss.

**Key Purpose**: Measure comparative significance of individual income statement and position statement items; assess profitability, solvency, and efficiency.

*(Detailed coverage in Chapter 5)*

5. **Cash Flow Analysis**

Analysis of actual movement of cash into and out of an organization.

**Key Terms**:

**Cash Inflow/Positive Cash Flow**: Cash flowing into the business

**Cash Outflow/Negative Cash Flow**: Cash flowing out of the business

**Net Cash Flow**: Difference between inflows and outflows

**Purpose**: Project manner of cash receipt and utilization during accounting year; show sources of cash and purposes of payments; summarize causes of changes in cash position between two balance sheet dates.

*(Detailed coverage in Chapter 6)*

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Comparative Statements: Detailed Preparation

Comparative statements show profitability and financial position for different periods, providing columns for current year, previous year, and changes in both absolute and relative terms. This enables identification of direction and trends in performance indicators.

**Comparative Statement of Profit and Loss**

**Format and Calculation**:

| Particulars | Year 1 (Rs.) | Year 2 (Rs.) | Absolute Increase/Decrease (Rs.) | Percentage Increase/Decrease (%) |

|---|---|---|---|---|

| Revenue from Operations | A | B | B - A | ((B - A) / A) × 100 |

| Add: Other Income | C | D | D - C | ((D - C) / C) × 100 |

| **Total Revenue** | A+C | B+D | (B+D) - (A+C) | ((B+D - A - C) / (A+C)) × 100 |

| Less: Expenses | E | F | F - E | ((F - E) / E) × 100 |

| **Profit before Tax** | A+C-E | B+D-F | Calculated | Calculated |

| Less: Tax | G | H | H - G | ((H - G) / G) × 100 |

| **Profit after Tax** | (A+C-E-G) | (B+D-F-H) | Calculated | Calculated |

**Worked Example** (from NCERT Illustration 1):

BCR Co. Ltd. - Comparative Statement of P&L for 2015-16 and 2016-17

Given:

Revenue from Operations: 2015-16 = Rs. 60,00,000; 2016-17 = Rs. 75,00,000

Other Income: 2015-16 = Rs. 1,50,000; 2016-17 = Rs. 1,20,000

Expenses: 2015-16 = Rs. 44,00,000; 2016-17 = Rs. 50,60,000

Tax Rate: 35% (2015-16), 40% (2016-17)

**Solution**:

| Particulars | 2015-16 (Rs.) | 2016-17 (Rs.) | Absolute Change (Rs.) | Percentage Change (%) |

|---|---|---|---|---|

| Revenue from Operations | 60,00,000 | 75,00,000 | 15,00,000 | 25.00 |

| Add: Other Income | 1,50,000 | 1,20,000 | (30,000) | (20.00) |

| **Total Revenue** | **61,50,000** | **76,20,000** | **14,70,000** | **23.90** |

| 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** |

| 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** |

**Calculations**:

Revenue increase: (75,00,000 - 60,00,000) / 60,00,000 × 100 = 25%

Other Income decrease: (1,20,000 - 1,50,000) / 1,50,000 × 100 = -20%

Total Revenue increase: (76,20,000 - 61,50,000) / 61,50,000 × 100 = 23.90%

Profit before Tax increase: (25,60,000 - 17,50,000) / 17,50,000 × 100 = 46.29%

Tax 2015-16: 17,50,000 × 35% = 6,12,500

Tax 2016-17: 25,60,000 × 40% = 10,24,000

Tax increase: (10,24,000 - 6,12,500) / 6,12,500 × 100 = 67.18%

PAT increase: (15,36,000 - 11,37,500) / 11,37,500 × 100 = 35.03%

**Interpretation**:

Revenue increased significantly by 25%, indicating growing sales

Other income decreased by 20%, possibly due to lower investment income

Expenses increased only 15%, showing better cost control despite higher sales

Profit before tax grew substantially at 46.29%, showing operational leverage

Tax burden increased at 67.18% due to both higher profit and higher tax rate

PAT still grew by 35.03%, indicating stronger bottom-line profitability

**Comparative Balance Sheet**

**Format**:

| Particulars | Date 1 (Rs.) | Date 2 (Rs.) | Absolute Change (Rs.) | Percentage Change (%) |

|---|---|---|---|---|

| Assets/Liabilities Item A | X | Y | Y - X | ((Y - X) / X) × 100 |

**Worked Example** (from NCERT Illustration 3):

J. Limited - Comparative Balance Sheet as at March 31, 2016 and March 31, 2017

Given Balance Sheet data:

| Particulars | March 31, 2016 (Rs.) | March 31, 2017 (Rs.) |

|---|---|---|

| **Equity and Liabilities** | | |

| Share Capital | 15,00,000 | 20,00,000 |

| Reserves and Surplus | 4,00,000 | 3,00,000 |

| Long-term Borrowings | 6,00,000 | 9,00,000 |

| Trade Payables | 2,00,000 | 3,00,000 |

| **Total** | **27,00,000** | **35,00,000** |

| **Assets** | | |

| Tangible Assets | 15,00,000 | 20,00,000 |

| Intangible Assets | 6,00,000 | 9,00,000 |

| Inventories | 4,00,000 | 3,00,000 |

| Cash and Cash Equivalents | 2,00,000 | 3,00,000 |

| **Total** | **27,00,000** | **35,00,000** |

**Solution** (in Lakhs):

| Particulars | March 31, 2016 | March 31, 2017 | Absolute Change | % Change |

|---|---|---|---|---|

| **Equity and Liabilities** | | | | |

| Share Capital | 15 | 20 | 5 | 33.33 |

| Reserves and Surplus | 4 | 3 | (1) | (25.00) |

| Long-term Borrowings | 6 | 9 | 3 | 50.00 |

| Trade Payables | 2 | 3 | 1 | 50.00 |

| **Total** | **27** | **35** | **8** | **29.63** |

| **Assets** | | | | |

| Tangible Assets | 15 | 20 | 5 | 33.33 |

| Intangible Assets | 6 | 9 | 3 | 50.00 |

| Inventories | 4 | 3 | (1) | (25.00) |

| Cash and Equivalents | 2 | 3 | 1 | 50.00 |

| **Total** | **27** | **35** | **8** | **29.63** |

**Calculations**:

Share Capital increase: (20 - 15) / 15 × 100 = 33.33%

Long-term Borrowings increase: (9 - 6) / 6 × 100 = 50%

Total increase: (35 - 27) / 27 × 100 = 29.63%

**Interpretation**:

Equity increased through both share capital increase (33.33%) and borrowings increase (50%)

Reserves decreased by 25%, possibly due to dividend distributions

Trade payables increased 50%, indicating extended credit terms

Fixed assets increased proportionately: tangible assets up 33.33%, intangible assets up 50%

Inventories decreased 25%, showing improved inventory management

Cash increased 50%, indicating improved liquidity position

Overall assets grew 29.63%, matching liability growth

**Key Points for Exam**:

Always maintain ratio of total liabilities equals total assets

Express percentage changes clearly with sign (+/-)

Highlight significant percentage changes (typically >20%) for interpretation

Compare changes in assets with changes in liabilities to understand financing strategy

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Common Size Statements (Vertical Analysis)

**Common Size Statements** express each item as a percentage of a common or base item, bringing all figures to a common denominator. This enables easy comparison across years and between firms.

**Common Size Income Statement**

**Base Item**: Typically **Revenue from Operations** (or Net Revenue)

**Formula for each item**: (Item Amount / Revenue from Operations) × 100

**Format**:

| Particulars | Year 1 (Rs.) | Year 1 (%) | Year 2 (Rs.) | Year 2 (%) |

|---|---|---|---|---|

| Revenue from Operations | A | 100 | B | 100 |

| Other Income | C | (C/A)×100 | D | (D/B)×100 |

| **Total Revenue** | A+C | - | B+D | - |

| Expenses | E | (E/A)×100 | F | (F/B)×100 |

| Profit before Tax | - | - | - | - |

| Tax | G | (G/A)×100 | H | (H/B)×100 |

| **Profit after Tax** | - | - | - | - |

**Interpretation**: Percentage shows what portion of each rupee of revenue is spent on expenses or profit, enabling analysis of profitability trends and cost structure changes.

**Common Size Balance Sheet**

**Base Item**: Typically **Total Assets** or **Total Liabilities and Shareholders' Funds**

**Formula for Liabilities Side**: (Item / Total Liabilities and Funds) × 100

**Formula for Assets Side**: (Item / Total Assets) × 100

**Format**:

| Particulars | Year 1 (Rs.) | Year 1 (%) | Year 2 (Rs.) | Year 2 (%) |

|---|---|---|---|---|

| **Equity and Liabilities** | | | | |

| Shareholders' Funds | A | (A/Total)×100 | B | (B/Total)×100 |

| Long-term Liabilities | C | (C/Total)×100 | D | (D/Total)×100 |

| Current Liabilities | E | (E/Total)×100 | F | (F/Total)×100 |

| **Total** | **A+C+E** | **100** | **B+D+F** | **100** |

| **Assets** | | | | |

| Fixed Assets | G | (G/Total)×100 | H | (H/Total)×100 |

| Current Assets | I | (I/Total)×100 | J | (J/Total)×100 |

| **Total** | **G+I** | **100** | **H+J** | **100** |

**Advantages of Common Size Statements**:

**Intra-firm Comparison**: Compare same company's performance across years to identify structural changes

**Inter-firm Comparison**: Compare companies of different sizes in the same industry

**Trend Identification**: Show whether percentages are increasing or decreasing

**Industry Benchmark**: Compare with industry averages or competitor percentages

**Interpretation Example**:

If Cost of Goods Sold percentage increased from 60% to 65% of sales, it indicates deteriorating profit margins

If Current Assets percentage of total assets decreased, it might indicate liquidity concerns

If Debt-to-Total Liabilities ratio increased, it shows higher financial leverage

**Key Points for Exam**:

Base item must be 100% in common size statements

Always show both absolute amounts and percentages

Highlight significant percentage-point changes (typically >5 pp)

Provide interpretation explaining what the changes mean for the business

Remember: common size statements are for internal/external analysis, not statutory requirement

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Trend Analysis

**Trend Analysis** is a technique that studies operational results and financial position over a series of years (typically 3+ years), analyzing percentage changes in selected data.

**Concept and Formula**

**Trend Percentage**: The percentage relationship that each item of different years bears to the same item in the **base year** (generally the earliest year in the series).

**Formula**:

**Trend Percentage = (Item Value in Current Year / Item Value in Base Year) × 100**

**Steps to Calculate Trend Percentages**

**Step 1**: Identify the base year (usually Year 1 or the earliest year) and assign it 100%

**Step 2**: For each subsequent year, divide that year's figure by the base year figure and multiply by 100

**Step 3**: Prepare a trend analysis table showing all percentages

**Step 4**: Analyze whether each item is increasing, decreasing, or remaining constant over time

**Example of Trend Analysis Calculation**

Suppose revenue figures over 5 years are:

Year 1 (Base): Rs. 50,00,000

Year 2: Rs. 55,00,000

Year 3: Rs. 60,00,000

Year 4: Rs. 63,00,000

Year 5: Rs. 68,00,000

Trend percentages:

Year 1: (50,00,000 / 50,00,000) × 100 = **100%**

Year 2: (55,00,000 / 50,00,000) × 100 = **110%**

Year 3: (60,00,000 / 50,00,000) × 100 = **120%**

Year 4: (63,00,000 / 50,00,000) × 100 = **126%**

Year 5: (68,00,000 / 50,00,000) × 100 = **136%**

**Interpretation**: Revenue has grown consistently, increasing by 36% from base year to Year 5. The growth rate is steady, indicating stable business expansion.

**Complete Trend Analysis Illustration**

If we analyze multiple items (Revenue, Expenses, Profit) over same period:

| Year | Revenue (Rs.) | Revenue (%) | Expenses (Rs.) | Expenses (%) | Profit (Rs.) | Profit (%) |

|---|---|---|---|---|---|---|

| 1 | 50,00,000 | 100 | 30,00,000 | 100 | 20,00,000 | 100 |

| 2 | 55,00,000 | 110 | 32,00,000 | 106.67 | 23,00,000 | 115 |

| 3 | 60,00,000 | 120 | 34,00,000 | 113.33 | 26,00,000 | 130 |

| 4 | 63,00,000 | 126 | 36,00,000 | 120 | 27,00,000 | 135 |

| 5 | 68,00,000 | 136 | 39,00,000 | 130 | 29,00,000 | 145 |

**Interpretation**:

Revenue increased 36% (100% to 136%)

Expenses increased 30% (100% to 130%)

**Profit increased 45% (100% to 145%)**

Since profit grew faster than expenses, expense management improved (profit margin expanding)

Growth is consistent year-on-year, indicating stable business operations

**Importance and Uses of Trend Analysis**

**Long-run View**: May reveal basic changes in business nature or structure

**Pattern Recognition**: Shows whether items are rising, falling, or stagnating

**Problem Detection**: Identifies deteriorating or improving performance

**Management Evaluation**: Helps assess quality of management decisions over time

**Forecasting**: Historical trends can support projections for future periods

**Comparative Position**: Shows relative position of items compared to base year

**Key Differences: Comparative vs. Trend Analysis**

| Aspect | Comparative Analysis | Trend Analysis |

|---|---|---|

| **Time Period** | Two consecutive years typically | Multiple years (3+) |

| **Base for Comparison** | Previous year | Base year (earliest year) |

| **Focus** | Year-to-year changes | Long-term direction and pattern |

| **Formula** | ((Current - Previous) / Previous) × 100 | (Current / Base) × 100 |

| **Insight** | Short-term performance change | Long-term strategic direction |

**Exam-Important Points on Trend Analysis**

Always identify the base year clearly; it is assigned 100%

Trend percentage can exceed 100% (showing growth) or be less than 100% (showing decline)

Trend analysis requires consistent accounting policies across all years for validity

If accounting policies change, note should be made and comparison adjusted

Trend lines can be drawn graphically to visualize patterns

Negative trend percentages are possible if items are liabilities decreasing

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Limitations of Financial Analysis

While financial statement analysis is a powerful tool, it has significant limitations that analysts must recognize:

**Limitations**:

1. **Based on Historical Data**: Financial statements reflect past transactions. Future business conditions may differ significantly, making historical analysis unreliable for prediction.

2. **Accounting Policies Variation**: If different accounting policies are used across periods or companies (depreciation methods, inventory valuation, revenue recognition), comparisons become unreliable. Uniform standards are necessary.

3. **Price Level Changes**: Financial statements use historical costs without adjusting for inflation. In inflationary periods, comparisons across years become distorted and difficult to interpret.

4. **Window Dressing**: Management may manipulate financial statements to present a better picture (timing of expenses, revenue recognition policies), making analysis misleading.

5. **Qualitative Factors Ignored**: Analysis focuses on quantitative data. Important qualitative factors (management quality, customer loyalty, market position, product quality, brand value) are not reflected in financial statements.

6. **Industry Differences**: Industry-specific factors (seasonal variations, capital intensity, technology requirements) affect ratios and metrics differently; inter-industry comparisons are often not meaningful.

7. **Limited to Published Information**: Analysis relies on financial statements. Critical internal management information may not be available to external analysts.

8. **Benchmark Issues**: In absence of clear industry benchmarks or standards, determining whether a ratio/metric is "good" or "bad" becomes subjective.

9. **Temporal Issues**: Single snapshot analysis at year-end may not represent typical business conditions; year-end transactions might be atypical.

10. **Ignores External Factors**: Regulatory changes, technological disruptions, economic recessions, and competitive threats are not reflected in historical financial data.

Despite these limitations, financial analysis remains essential. Analysts should use it as one tool among many and supplement it with qualitative analysis, industry knowledge, and future-focused assessment.

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Summary of Key Concepts for Board Exam

**Definition**: Financial Statement Analysis is critical evaluation of financial data to assess operational efficiency, profitability, and financial health.

**Two Core Components**:

Analysis (simplification and classification of data)

Interpretation (explaining meaning and significance)

**Main Users**: Finance managers, top management, trade payables, lenders, investors, labour unions, economists, government agencies.

**Key Objectives**: Assess profitability and efficiency, determine financial position components, identify reasons for changes, judge debt repayment ability.

**Five Main Tools**:

1. **Comparative Statements** (Horizontal Analysis): Two-period comparison with absolute and percentage changes

2. **Common Size Statements** (Vertical Analysis): Express items as percentages of base item

3. **Trend Analysis**: Multi-year percentage changes from base year (100%)

4. **Ratio Analysis**: Relationships between financial statement items (Chapter 5)

5. **Cash Flow Analysis**: Movement of cash inflows and outflows (Chapter 6)

**Exam-Focused Formats**:

Comparative P&L and Balance Sheets with absolute and percentage columns

Common size statements showing both amounts and percentages

Trend analysis tables across 3-5 years

Interpretation explaining what figures mean for business

Identification of significant changes (>20% typically noteworthy)

**Critical Point**: Analysis alone without interpretation is incomplete; always provide meaningful explanation of findings and what they indicate about financial health, operational performance, and business direction.