Analysis of financial statements means examining the financial data contained in financial statements to understand the financial health, performance, and prospects of a business. It helps various stakeholders — investors, creditors, management, government — make informed decisions.
Meaning and Purpose
- Financial statement analysis involves:
- Identifying the relationship among financial items.
- Comparing data over time (trend analysis) or across firms (inter-firm comparison).
- Interpreting results to assess liquidity, solvency, profitability, and efficiency.
- Objectives:
- Assess earning capacity and profitability.
- Assess short-term and long-term solvency.
- Identify operational efficiency.
- Support inter-firm comparison.
- Assist in forecasting and planning.
Parties Interested in Analysis
- Management: Internal control, planning, and efficiency improvement.
- Investors: Dividend prospects and safety of investment.
- Creditors: Ability to repay short-term/long-term obligations.
- Government: Tax assessment and regulation.
- Employees: Job security and wage negotiation.
- Analysts/Researchers: Academic and investment research.
Types of Financial Analysis
Based on Material Used
- External analysis: By outsiders (investors, creditors) using published statements.
- Internal analysis: By management using all available internal records.
Based on Modus Operandi
- Horizontal analysis (Comparative analysis): Comparing data of the same firm over two or more periods; reveals trends and growth.
- Vertical analysis (Common-size analysis): Each item is expressed as a percentage of a base figure within a single period. Assets are expressed as % of total assets; P&L items as % of net revenue.
Tools of Financial Analysis
- 1.Comparative Financial Statements
- 2.Common-size Financial Statements
- 3.Trend Analysis
- 4.Accounting Ratios
- 5.Cash Flow Analysis
Comparative Financial Statements
Comparative statements show financial data for two or more periods side by side, with absolute change (increase/decrease) and percentage change computed.
Format columns: Particulars | Year 1 | Year 2 | Absolute Change (Rs.) | % Change
Worked Example 1: Comparative Balance Sheet
Revenue from Operations: Year 1 = Rs. 8,00,000; Year 2 = Rs. 10,00,000.
Absolute Change = Rs. +2,00,000; % Change = (2,00,000 / 8,00,000) x 100 = 25% increase.
Worked Example 2: Comparative P&L Interpretation
Net Profit: Year 1 = Rs. 60,000; Year 2 = Rs. 45,000.
Absolute Change = -Rs. 15,000; % Change = (-15,000 / 60,000) x 100 = -25% (decrease).
This signals declining profitability and warrants investigation into rising costs or falling revenue.
Common-Size Financial Statements
- Each item is expressed as a percentage of a common base:
- In Balance Sheet: Base = Total Assets (or Total Equity + Liabilities)
- In P&L Statement: Base = Revenue from Operations (Net Revenue)
Worked Example 3: Common-Size Balance Sheet
Total Assets = Rs. 5,00,000.
Fixed Assets = Rs. 3,00,000 → 3,00,000 / 5,00,000 x 100 = 60%.
Current Assets = Rs. 2,00,000 → 40%.
This shows 60% of funds are locked in fixed assets.
Worked Example 4: Common-Size P&L
Revenue from Operations = Rs. 10,00,000 (= 100%).
Cost of Revenue = Rs. 6,00,000 → 60%.
Gross Profit = Rs. 4,00,000 → 40%.
Net Profit = Rs. 1,20,000 → 12%.
A company with a 12% net margin is moderately profitable.
Trend Analysis
Trend analysis expresses each year's data as a percentage of the base year (= 100). It highlights the direction and speed of change over time.
Formula: Trend % = (Current Year Value / Base Year Value) x 100
Worked Example 5: Trend Analysis
Sales: 2021 = Rs. 5,00,000 (base year = 100); 2022 = Rs. 6,00,000; 2023 = Rs. 7,50,000; 2024 = Rs. 9,00,000.
Trend %: 2021 = 100; 2022 = 120; 2023 = 150; 2024 = 180.
This shows a consistent upward sales trend — a positive signal.
Worked Example 6: Limitations of Trend Analysis
If a company shows rising revenue trend but costs have grown faster, profits may still decline. Trend analysis must be read with ratio analysis for a complete picture.
Worked Example 7: Identifying a Common-Size Concern
Company A: SG&A expenses = 35% of revenue (common-size); Industry average = 20%.
This signals that Company A has significantly higher administrative expenses than peers — a sign of operational inefficiency.
Limitations of Financial Analysis
- Based on historical data — does not reflect current or future reality.
- Affected by changes in accounting policies — makes comparisons unreliable.
- Window dressing by management can distort statements.
- Price level changes (inflation) make year-to-year comparisons misleading.
- Does not capture qualitative factors (management quality, employee morale).
- Seasonal businesses may show distorted ratios at certain points in time.
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Common mistakes
- Computing % change with the wrong base — always use the earlier period's figure as the base for % change in comparative analysis.
- Confusing horizontal and vertical analysis: horizontal compares across periods; vertical compares items within one period as % of a base.
- In trend analysis, assigning any percentage other than 100 to the base year.
- Using total equity as the base in common-size Balance Sheet instead of total assets/total equity and liabilities (both sides are equal).
Summary
Financial statement analysis uses tools like comparative statements, common-size statements, trend analysis, ratios, and cash flow analysis. Horizontal analysis compares two or more periods; vertical analysis expresses items as a percentage of a base. Trend analysis shows direction of change. All tools have limitations, especially regarding historical data and qualitative factors.