Class 12 Accountancy Notes Chapter 4 (Analysis of Financial Statements) – Accountancy-II Book

Alright, let's focus on Chapter 4: Analysis of Financial Statements from your Accountancy-II NCERT book. This is a crucial chapter, not just for your board exams but also forms the foundation for many questions in government recruitment exams involving commerce or accounts backgrounds.

Chapter 4: Analysis of Financial Statements - Detailed Notes

1. Meaning of Financial Statements:

• Financial statements are the summarised reports of a company's financial activities over a period (Income Statement/Statement of Profit & Loss) and its financial position at a specific point in time (Balance Sheet).
• Key components (as per Schedule III of the Companies Act, 2013):
  • Balance Sheet: Shows Assets, Liabilities, and Equity.
  • Statement of Profit and Loss: Shows Revenues earned and Expenses incurred during the accounting period.
  • Notes to Accounts: Provides detailed explanations and break-downs of items presented in the Balance Sheet and Statement of P&L.
  • Cash Flow Statement: (Studied in detail later, but part of the overall set) Shows inflows and outflows of cash and cash equivalents.

2. Meaning of Financial Statement Analysis:

• It is the process of critically examining the financial information contained in the financial statements.
• The goal is to understand the financial performance (profitability) and financial position (solvency and liquidity) of the business.
• It involves establishing relationships between various items in the financial statements and interpreting the results to make informed decisions.
• It simplifies complex financial data into understandable and usable information.

3. Objectives of Financial Statement Analysis:

• Assess Profitability: To determine the earning capacity of the business (e.g., Gross Profit Ratio, Net Profit Ratio).
• Assess Financial Position/Solvency: To judge the long-term ability of the firm to meet its liabilities (e.g., Debt-Equity Ratio) and short-term ability to meet current obligations (Liquidity, e.g., Current Ratio).
• Assess Efficiency: To evaluate how efficiently the resources of the firm are being utilized (e.g., Inventory Turnover Ratio, Working Capital Turnover Ratio).
• Inter-firm Comparison: To compare the performance of the firm with other firms in the same industry.
• Intra-firm Comparison: To compare the performance of the firm over different time periods (trend analysis).
• Forecasting and Budgeting: To help in predicting future performance and preparing budgets.
• Decision Making: To provide valuable information for various stakeholders (management, investors, creditors, etc.) to make rational decisions.

4. Importance/Significance of Financial Statement Analysis:

• For Management: Helps in performance evaluation, control, planning, and decision making.
• For Investors: Helps in deciding whether to invest, hold, or sell shares by assessing profitability and financial health.
• For Lenders/Creditors: Helps in determining the creditworthiness and solvency of the firm before granting loans or credit.
• For Government & Tax Authorities: Helps in assessing tax liabilities and ensuring compliance with regulations.
• For Employees & Trade Unions: Helps in assessing the firm's ability to pay higher wages and provide job security.
• For Researchers: Provides data for industry analysis and economic studies.

5. Tools or Techniques of Financial Statement Analysis:
(This chapter primarily focuses on the first two, while others are covered in subsequent chapters but are part of the overall toolkit)

• Comparative Statements: Comparing financial statement items of two or more years side-by-side to identify trends.
• Common-Size Statements: Expressing all items of a financial statement as a percentage of a common base (e.g., Total Assets for Balance Sheet, Revenue from Operations for P&L).
• Ratio Analysis: Calculating various ratios to analyze profitability, liquidity, solvency, and efficiency (Detailed in Chapter 5).
• Cash Flow Analysis: Analyzing the inflows and outflows of cash (Detailed in Chapter 6).
• Trend Analysis: Analyzing the trend of individual items over several years.

6. Detailed Look at Tools (Focus of Chapter 4):

**a) Comparative Statements:**
*   **Purpose:** To study the trend and direction of change in individual items of the Balance Sheet and Statement of P&L over two or more periods.
*   **Method:**
    *   Items from the financial statements for two periods (current and previous) are placed side-by-side.
    *   **Absolute Change:** Calculated by subtracting the previous year's figure from the current year's figure (Current Year - Previous Year).
    *   **Percentage Change:** Calculated as: `(Absolute Change / Previous Year's Figure) * 100`.
*   **Format:** Typically includes columns for: Particulars, Previous Year Amount, Current Year Amount, Absolute Change (Increase/Decrease), Percentage Change (Increase/Decrease).
*   **Types:**
    *   **Comparative Balance Sheet:** Shows changes in Assets, Liabilities, and Equity.
    *   **Comparative Statement of Profit and Loss:** Shows changes in Revenue, Expenses, and Profit.
*   **Interpretation:** Helps identify significant increases or decreases in items, indicating areas of growth, decline, or concern.

**b) Common-Size Statements:**
*   **Purpose:** To study the structural composition of financial statements and compare the proportion of each item to a common base, either over time (intra-firm) or with other firms (inter-firm). Also known as Vertical Analysis.
*   **Method:**
    *   Each item in the financial statement is expressed as a percentage of a common base figure for the *same period*.
    *   **For Balance Sheet:** The common base is usually 'Total Assets' or 'Total Equity and Liabilities'. Each asset is shown as % of Total Assets; each liability/equity item is shown as % of Total Equity & Liabilities.
    *   **For Statement of Profit and Loss:** The common base is usually 'Revenue from Operations' (Net Sales). Each item of expense and profit is shown as a % of Revenue from Operations.
*   **Format:** Typically includes columns for: Particulars, Absolute Amounts (Current Year, Previous Year), Percentage of Base (Current Year, Previous Year).
*   **Types:**
    *   **Common-Size Balance Sheet:** Shows the percentage of each asset to total assets and each liability/equity item to total liabilities & equity. Reveals the asset mix and financing pattern.
    *   **Common-Size Statement of Profit and Loss:** Shows the percentage of each expense/profit item to Revenue from Operations. Reveals the contribution of each expense to sales and the profit margins.
*   **Interpretation:** Helps understand the relative significance of each item and identify structural changes over time or differences compared to competitors.

7. Types of Financial Statement Analysis:

• Based on Material Used:
  • External Analysis: Conducted by outsiders (investors, lenders, agencies) based on published financial statements.
  • Internal Analysis: Conducted by management using both published and internal, detailed information.
• Based on Modus Operandi (Method):
  • Horizontal Analysis: Comparison of financial data over a series of reporting periods (e.g., Comparative Statements, Trend Analysis). It focuses on changes across time.
  • Vertical Analysis: Comparison of different items within the same financial statement for a single period (e.g., Common-Size Statements, Ratio Analysis). It focuses on relationships within a period.

8. Limitations of Financial Statement Analysis:

• Historical Data: Analysis is based on past data, which may not accurately predict the future.
• Ignores Price Level Changes: Financial statements are prepared at historical cost and do not reflect changes in purchasing power due to inflation.
• Ignores Qualitative Aspects: Factors like management quality, employee morale, brand reputation, competition, etc., are not reflected in financial statements but significantly impact performance.
• Variations in Accounting Practices: Different firms may use different accounting policies (e.g., depreciation methods, inventory valuation), making comparisons difficult.
• Window Dressing: Companies might manipulate figures to present a better picture than what actually exists (e.g., postponing expenses, overvaluing assets).
• Subjectivity/Personal Bias: Interpretation of analysed data can be influenced by the analyst's personal judgment and bias.
• Not Absolute: Analysis provides indicators, not definitive conclusions. It should be used along with other information.

Multiple Choice Questions (MCQs) for Practice:

1. The primary goal of Financial Statement Analysis is to:
   a) Prepare the Balance Sheet accurately.
   b) Understand the performance and financial position of the business.
   c) Calculate the exact future profit.
   d) Record all business transactions.
   Answer: b)

2. Which of the following is a tool for Financial Statement Analysis?
   a) Trial Balance
   b) Journal Entries
   c) Ratio Analysis
   d) Ledger Posting
   Answer: c)

3. In Comparative Statements, financial data for _______ is compared.
   a) A single year
   b) Two or more different companies
   c) Two or more accounting periods of the same company
   d) A single department within the company
   Answer: c)

4. In a Common-Size Balance Sheet, each asset is expressed as a percentage of:
   a) Net Profit
   b) Revenue from Operations
   c) Total Assets
   d) Total Liabilities
   Answer: c)

5. Calculating the percentage change in Sales from Year 1 to Year 2 is an example of:
   a) Vertical Analysis
   b) Ratio Analysis
   c) Horizontal Analysis
   d) Cash Flow Analysis
   Answer: c)

6. Expressing Selling Expenses as a percentage of Revenue from Operations is an example of:
   a) Horizontal Analysis
   b) Trend Analysis
   c) Comparative Statement
   d) Vertical Analysis (Common-Size Statement)
   Answer: d)

7. Which of the following is a limitation of Financial Statement Analysis?
   a) It helps in decision making.
   b) It ignores qualitative aspects.
   c) It assesses profitability.
   d) It facilitates comparison.
   Answer: b)

8. 'Window Dressing' in the context of financial statements refers to:
   a) Decorating the company office.
   b) Presenting financial data in an attractive format.
   c) Manipulation of accounts to show a more favourable position.
   d) Analysing statements near the end of the accounting year.
   Answer: c)

9. External users of financial statement analysis typically include:
   a) Management only
   b) Potential Investors and Lenders
   c) Department Heads
   d) Internal Auditors
   Answer: b)

10. In a Comparative Statement of Profit and Loss, the 'Absolute Change' is calculated as:
    a) (Current Year Amount / Previous Year Amount) * 100
    b) Current Year Amount - Previous Year Amount
    c) (Absolute Change / Previous Year Amount) * 100
    d) Current Year Amount + Previous Year Amount
    Answer: b)

Remember to thoroughly understand the concepts, formats, and calculations for Comparative and Common-Size statements, as they are the core focus of this specific chapter. Good luck with your preparation!