NCERT Class 12 Accountancy Chapter 8 Analysis of Financial Statements

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NCERT Class 12 Accountancy Chapter 8 Analysis of Financial Statements

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Analysis of Financial Statements

Chapter: 8

PART – II

Short Answer Questions: 

1. List the techniques of Financial Statement Analysis. 

Ans: The most commonly used techniques of financial analysis are as follows: 

(i) 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.

(ii) 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.

(iii) 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. 

(iv) 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.

(v) Cash Flow Analysis: It refers to the analysis of actual movement of cash into and out of an organisation.

2. Distinguish between Vertical and Horizontal Analysis of financial data. 

Ans:

Vertical analysis	Horizontal Analysis
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’.	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’.

3. State the meaning of Analysis and Interpretation.

Ans: 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 without interpretation, and interpretation without analysis is difficult or even impossible.

4. State the importance of Financial Analysis? 

Ans: The importance of financial analysis are:

(i) Finance manager: Financial analysis focuses on the facts and relationships related to managerial performance, corporate efficiency, financial strengths and weaknesses and creditworthiness of the company.

(ii) 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.

(iii) 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.

(iv) Suppliers of long-term debt are concerned with the firm’s long term solvency and survival.

(v) 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. 

(vi) 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. 

(vii) 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.

5. What are Comparative Financial Statements? 

Ans: Comparative Financial 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.

6. What do you mean by Common Size Statements?

Ans: Common Size Statement 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.

Long Answer Questions

1. Describe the different techniques of financial analysis and explain the limitations of financial analysis.

Ans: The most commonly used techniques of financial analysis are as follows:

(i) 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. 

(ii) 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.

(iii) 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.

(iv) 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.

(v) 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.

Some limitations of financial analysis are: 

(i) Financial analysis does not consider price level changes. 

(ii) Financial analysis may be misleading without the knowledge of the changes in accounting procedure followed by a firm. 

(iii) Financial analysis is just a study of reports of the company. 

(iv) Monetary information alone is considered in financial analysis while non-monetary aspects are ignored. 

(v) The financial statements are prepared on the basis of accounting concept, as such, it does not reflect the current position.   

2. Explain the usefulness of trend percentages in interpretation of financial performance of a company. 

Ans: 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 complementary to each other. Analysis is useless without interpretation, and interpretation without analysis is difficult or even impossible.

3. What is the importance of comparative statements? Illustrate your answer with particular reference to comparative income statement. 

Ans: Comparative statements refer to the statement of profit and loss and the balance sheet prepared by providing columns for the figures for both the current year as well as for the previous year and for the changes during the year, both in absolute and relative terms. As a result, it is possible to find out not only the balances of accounts as on different dates and summaries of different operational activities of different periods, but also the extent of their increase or decrease between these dates. The figures in the comparative statements can be used for identifying the direction of changes and also the trends in different indicators of performance of an organisation.

Illustration 1 Convert the following statement of profit and loss of BCR Co. Ltd. into the comparative statement of profit and loss of BCR Co. Ltd.

Particulars	Note. No.	2015-16(Rs.)	2016-17(Rs.)
(i) Revenue from operations		60,00,000	75,00,000
(ii) Other incomes		1,50,000	1,20,000
(iii) Expenses		44,00,000	50,60,000
(iv) Income tax		35%	40%

Solution:

Comparative statement of profit and loss of BCR Co. Ltd. for the year ended March 31, 2016 and 2017:

Particulars	2015-16	2016-17	Absolute increase (+) or decrease(-)	Percentage increase (+) or decrease (-)
	(Rs.)	(Rs.)	(Rs.)	(Rs.)
I. Revenue from operations II. Add: Other incomes	60,00,000 1,50,000	75,00,000 1,20,000	15,00,000 30,000	25.00 20.00
III. Total Revenue I+II IV. Less: Expenses	61,50,000 44,00,000	76,20,000 50,60,000	14,70,000  6,60,000	23.90 15.00
Profit before tax V. Less: Tax	17,50,000 6,12,500	25,60,000 10,24,000	8,10,000  4,11,500	46.29 67.18
Profit after tax	11,37,500	15,36,000	3,98,500	35.03

4. What do you understand by analysis and interpretation of financial statements? Discuss its importance.

Ans: 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 complementary to each other. Analysis is useless without interpretation, and interpretation without analysis is difficult or even impossible.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.

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.

(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 used most efficiently and that the firm’s financial condition is sound.

(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. 

(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.

5. Explain how common size statements are prepared giving an example.

Ans: The following procedure may be adopted for preparing the common size statements. 

(i) List out absolute figures in rupees at two points of time, say year 1, and year 2 (Column 2 & 4 of Exhibit 4.2). 

(ii) Choose a common base (as 100). For example, revenue from operations may be taken as base (100) in case of statement of profit and loss and total assets or total liabilities (100) in case of balance sheet. 

(iii) For all items of Col. 2 and 3 work out the percentage of that total. Column 4 and 5 shows these percentages in Exhibit 4.2. 

Common Size Statement

Particulars	Year One	Year Two	Year Of year 1	Year Of year 2
1	2	3	4	5