Chapter 3

Analysis of Financial Statements

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Chapter Outline

Introduction
What do we mean by Analysis?
What is Financial Statement Analysis?
Purposes of Financial Statement Analysis
Chapter Outline Parties interested in Financial Statement Analysis
Types of Financial Statement Analysis
Procedure adopted for analysis and interpretation
Methods of Financial Statement Analysis
Comparative financial statements
Common size statements
Trend analysis
Ratio analysis
Funds flow analysis
Cash flow analysis
Ratio analysis
Limitation of financial statement analysis

Introduction

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In the last chapter we have learnt about the preparation of financial statements. But it is very difficult to
understand the picture painted by the accounts just by looking at them. Some companies publish their annual
reports running into 100 pages or more. Thus, the financial statements in their original form are not adequately
helpful in drawing a meaningful conclusion. The accounts are, therefore, summarized and analyzed with the help of
different tools such as; comparative statement, common size statement, ratio analysis, trend analysis, fund flow
analysis, cash flow analysis, etc. In this process a meaningful relationship is established between two or more
accounting figures for comparison. Trends are spotted and future is forecasted. How it is done is the subject matter
of this chapter. 
What do we mean by Analysis?
In simple words, analysis means ‘breakup’, just like dismantling. An analyst would deconstruct the statements, or
carry out reverse-engineering process, in order to make deeper sense of business performance. For example, in a
year the total sales were Rs.150 million. In order to analyse, we can break the total sales month-wise, territory-
wise or variety-wise or a combination thereof. It would now be easy to spot the highest and lowest level in each
segment. Adding one or more years with the same breakdown, one can get a clue of the peak month, most
lucrative territory or a top-selling variety. 
What is Financial Statement Analysis?
The Financial statements provide a summary
The term financial statement analysis, otherwise known as analysis
and interpretation of financial statements, refers to the establishing
of accounts of a business enterprise, the
meaningful relationship between various items of the financial balance sheet reflecting the assets, liabilities
statements. It determines financial strength and weaknesses of the and capital as on a certain date and the
firm. Analysis of financial statements is an attempt to assess the income statement showing the results of
efficiency and performance of an enterprise. operations during a certain period- John N.
Myer
Thus, the analysis financial statement is a process of evaluating the
relationship between the component parts of the financial statements The end product of financial accounting in a
to obtain a better understanding of a firm’s position and set of financial statements prepared by the
performance. It is very essential to measure the efficiency, accounts of a business enterprise that
profitability, financial soundness and future prospects of the business purport to reveal the financial position of the
units. enterprise, the result of its recent activities
Purposes of Financial Statement Analysis and an analysis of what has been done with
earnings- Smith and Asburne
The analysis and interpretation of financial statements is very
essential to measure the efficiency, profitability, financial soundness Financial statements, essentially, are interim
and future prospects of the business units. Financial analysis serves reports presented annually and reflect a
the following purposes: division of the life of an enterprise into more
or less arbitrary accounting period more
a) Measuring the profitability:
frequently a year- Anthony,
The main objective of a business is to earn a satisfactory return
on the funds invested in it. Financial analysis helps in ascertaining The analysis and interpretation of financial
whether adequate profits are being earned on the capital invested statements are an attempt to determine the
in the business or not. It also helps in knowing the capacity to significance and meaning of financial
pay the interest and dividend. statement data so that the forecast may be
b) Indicating the trend of achievements: made of the prospects for future earnings,
ability to pay interest and debt maturities and
Financial statements of the previous years can be compared and profitability and sound dividend policy-
the trend regarding various expenses, purchases, sales, gross
Kennedy and Muller
profits, net profit etc. can be ascertained. Value of assets and
liabilities can be compared and the future prospects of the
business can be envisaged.
c) Assessing the growth potential of the business:
The trend and other analysis provide sufficient information indicating the growth potential of the business.
d) Comparative position in relation to other firms:
The purpose of financial statements analysis is to help the management to make a comparative study of the
profitability of various firms engaged in similar businesses. Such comparison helps the management to study
the position of their firm in respect of sales, expenses, profitability and utilising capital, etc with respect to other
firms.
e) Assessing overall financial strength:
The financial statement analysis aims at assessing the financial strength of the business. It also helps in taking
decisions, whether funds required for the purchase of new machines and equipments are provided from internal
sources of the business or external. Then how much from internal source and how much from external source?
f) Assessing solvency of the firm:

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 The different tools of financial statements analysis evaluates whether the firm has sufficient funds to meet its
short and long term liabilities or not. It is otherwise called solvency of the firm.
Parties interested in Financial Statement Analysis
Analysis of financial statements has become very significant due to extensive interest of different parties in the
financial results of a business unit. The parties interested in the analysis of financial statements are:
(i) Investors and potential investors:
The present investors want to decide whether they should hold the securities of the company or sell them.
Potential investors, on the other hand, want to know whether they should invest in the shares of the
company or not. Investors (Shareholders or owners) and potential investors, thus, make use of the financial
statements to judge the present and future earning capacity of the business, to judge the operational
efficiency of the business and to know the safety of their investment and growth prospects of the company.
(ii) Lenders/long term creditors:
Financial statement analysis helps lenders such as; debenture holders, suppliers of loans and leases in
ascertaining the long and short term solvency of the business. They like to know the financial soundness of
the business i.e. the ability of the business to repay debt on maturity and earnings of the enterprise to pay
interest regularly.
(iii) Management:
Analysis of financial statements enables the management to evaluate the overall efficiency of the firm. It
helps to ascertain the solvency of the enterprise; to know about its viability as a going concern and to
provide adequate information for planning and controlling the affairs of the business. Future forecasts can
easily be made by analyzing the past data.
(iv) Suppliers/short term creditors:
Creditors/suppliers supplying goods to a business are interested to know whether the business would be in a
position to pay their dues in time or not. They are interested in short-term solvency i.e. the liquidity of the
business. They are more interested in current assets and current liabilities. If current assets are sufficient,
say, twice the current liabilities, they are satisfied that the business would be able to discharge the short-
term debts in time.
(v) Employees and Trade Unions:
Employees are interested in better emoluments, bonus and continuation of business. They are more
interested in deposit of their dues like; provident fund, ESI etc. with the authorities. They would therefore,
like to know financial performance and profitability and operating sustainability of the business.
(vi) Government and its agencies:
Financial statements are used by government and its agencies to formulate policies to regulate the activities
of business, formulate taxation policies, and compile national income accounts. Taxation authorities such
as; income tax department use the financial statements for determination of income tax; sales tax
department is interested in sales, while the excise department is interested in production. All these
information can be available only by analysing the financial statements.
(vii) Researchers:
The researchers are interested in financial statements in undertaking research work in business affairs and
practices.
(viii) Stock exchanges:
Stock exchange uses the financial statements to analyze and thereafter, inform its members about the
performance, financial health, etc. of the company, to see whether financial statements prepared are in
conformity with the specified laws and rules and to see whether they safeguard the interest of various
concerned agencies.
(ix) Other Regulatory authorities:
Other Regulatory authorities; like, Company Law Board, SEBI, Tax Authorities etc. would like that the
financial statements prepared are in conformity with the specified laws and rules, and are to safeguard the
interest of various concerned agencies. For example, taxation authorities would be interested in ensuring
proper assessment of tax liability of the enterprise as per the laws in force from time to time.
(x) Customers:
Customers are interested to ascertain continuance of an enterprise. For example, an enterprise may be
supplier of a particular type of consumer goods and in case it appears that the enterprise may not continue
for a long time, the customer has to find an alternate source.
Thus, we find that different parties have interest in analysis of financial statements for different reasons.
Types of Financial Statement Analysis

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There are many types of financial statement analysis and accountants use these as per their requirement and
comfort. Some important type are discussed below:
Internal Analysis:
An internal financial statement analysis is done by insiders of the firm who have access to all the financial
information. For example, analysis done by the top management, finance manager, employees, etc. can be termed
as internal financial statement analysis.
External Analysis:
External analysis is an analysis done by outsiders to the business firms, who have limited access to financial
information.
Horizontal Analysis:
In case of horizontal analysis the financial statements are analyzed horizontally. Examples of horizontal analysis
are comparative statement analysis and trend analysis. In this case one item for the current year is compared with
the same item for preceding year to predict for the future. More than one year's financial statements of companies
are essential for this type of analysis.
Vertical Analysis:
In case of vertical analysis only one year's financial statement is required. The analysis is done vertically in this
case. A particular item, e.g. net sales in income statement and total capital in Balance sheet is compared with all
other items.
Dynamic Analysis:
In case of dynamic analysis more than one year's financial data is essential. Examples of dynamic analysis are
ratios calculated for more than one year, comparative statement analysis, trend analysis, etc. Such an analysis has
broader scope since it facilitates comparison over a period of time i.e. year-to-year comparison.
Static Analysis:
In static analysis, only one year's financial data are utilized. It has limited scope since year-to-year comparison
cannot be done. Examples of static analysis are ratios calculated for only one year, common size analysis, etc.
Long Term Analysis:
In this case the long-tem solvency, stability and profitability positions are judged. It is helpful for long term
providers of funds. It judges the company's position over a period of time and not just for one year or less than
that.
Short Term Analysis:
It is helpful for short-term providers of funds, mainly trade creditors and bank overdraft. It is mainly concerned
with analysis of the firm working capital management.
Intra Firm Analysis:
Intra firm analysis is used for comparing the financial performance of the one business firm over a period of time.
Past years performance is compared with the current year's performance which indicates direction in which the
business firm is moving. For intra firm analysis, techniques like; ratio analysis, common size analysis, comparative
analysis and trend analysis are used.
Inter Firm Analysis:
Inter-Firm analysis is used to compare the financial figures of two firms from the same industry for the same
period. It helps to know which firm is having a comparatively better performance. Techniques like ratio analysis,
common size analysis and comparative analysis are used for inter-firm analysis.
Cross-sectional Analysis or Inter-firm comparison:
Under this technique of analysis, financial statements of one firm are compared with financial statements of
one/more similar other firms for judging the position of profitability, solvency, liquidity, credit worthiness, etc.
Under this technique the comparative financial characteristics of an enterprise are prepared with other comparable
enterprises.
Time series Analysis or Intra-firm comparison:
This reflects the movement of various financial characteristics over a period of time. Under this technique, the
financial characteristics of a firm are compared over a number of years so as to know the directions in which the
firm is moving.
Cross Sectional-cum-time series analysis:
This is the most effective approach of financial statement analysis and compares the financial characteristics of two
or more enterprises for a defined accounting period.
These are different types of financial statement analysis that are used by companies to know where they stand in
the market and it also helps them to know where their competitors stand. Financial Statement analysis is very
important as it give information about financial satiability of the company.

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Procedure adopted for analysis and interpretation of financial statements

Financial statement analysis involves careful selection of data from financial statements for the primary purpose of
forecasting the financial health of the company. This is accomplished by examining trends in key financial data,
comparing financial data across companies, and analyzing key financial ratios. However, the following procedure is
adopted for Analysis and Interpretation of Financial Statements.
(i) Basic knowledge regarding plans and policies of the management:
The analyst must know the plans and policies of the management so that he can be able to find out whether
these policies are properly executed or not.
(ii) Selection of required information:
The extent of analysis should be determined so that the sphere of work may be decided. If the aim is to find
out the earning capacity of the enterprise, then analysis of profit and loss account should be undertaken. On
the other hand, if financial position is to be studied then balance sheet analysis is necessary.
(iii) Methodical classification of the data:
The financial data given in the statements should be restructured and rearranged. Similar data is grouped
under same heads and individual components are broken down according to their nature, i.e. the data is
reduced to regular form.
(iv) Establishing the relationship:
A relationship is established among financial statements with the help of tools and techniques of analysis
such as ratios, trends, common size, funds flow, etc.
(v) Interpretation and drawing of conclusions:
The information is interpreted in a simple and understandable way. The significance and utility of financial
data analysis depends to greater extent how the interpretation is made. Therefore it must be explained in a
way which it will be helpful in decision-taking.
(vi) Reporting to the management:
Lastly, the conclusions drawn from interpretation are presented to the management in the form of reports.

Methods of Financial Statement Analysis

The analysis and interpretation of financial statements is used to determine the financial position of an
organisation. A number of tools are used to study the relationship between financial statements. However, the
following are the important tools which are commonly used for analysing and interpreting financial statements:
a) Comparative financial statements
b) Common size statements
c) Trend analysis
d) Ratio analysis
e) Funds flow analysis
f) Cash flow analysis
In this chapter, we shall have a detail discussion about the first three techniques; whereas the last three
techniques will be covered chapters 4, 5 and 6 respectively.

(A) Comparative Financial Statements

The comparative financial statements are statements of the financial position at different periods of time. The
elements as shown in a comparative form give an idea of financial position at two or more periods. From practical
point of view, two financial statements (balance sheet and income statement) are prepared in comparative form for
analysis purposes. A comparative statement may show:
 Absolute figures.
 Change in absolute figures.
 Absolute data in terms in percentage.
 Change in terms of percentage.

Absolute change = Amount in Current Period – Amount in Base Period

% of Change = (Absolute change / Base year amount)*100

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In brief, comparative study of financial statements is the comparison of the financial statements of the business
with the previous year’s financial statements. It enables identification of weak points and applying corrective
measures there on.
Advantages
(i) The comparative statements indicate trends in sales, cost of production, profits, etc., helping the analyst
to evaluate the performance, efficiency and financial condition of an undertaking. For example, if the sales
are increasing coupled with the same or better profit margins, it indicates healthy growth.
(ii) Comparative statements can also be used to compare the position of the firm with the average
performance of the industry or with other firms. Such a comparison facilitates the identification or
weaknesses and remedying the situation.
Disadvantages
(i) Inter-firm comparison may be misleading if the firms are not of the same age and size or follow different
accounting policies in relation to depreciation, valuation of stock, etc., and do not cater to the same
market.
(ii) Inter-period comparison will also be misleading, if the period has witnessed frequent changes in
accounting policy.

Types of Comparative Financial Statements

Comparative statements are of two types:

a) Comparative Balance Sheet
b) Comparative Profit and Loss Account

(a) Comparative Balance Sheet

A comparative balance sheet shows the different assets and liabilities of the firm on different dates to make
comparison of balances from one date to another. The comparative balance sheet has two columns for the data of
original balance sheets. A third column is used to show change (increase/decrease) in figures. The fourth column
may be added for giving percentages of increase or decrease. While interpreting comparative Balance sheet the
interpreter is expected to study the following aspects:
 Current financial position and Liquidity position
 Long-term financial position
 Profitability of the concern
(i) For studying current financial position or liquidity position of a concern, one should examine the working
capital in both the years. Working capital is the excess of current assets over current liabilities.
(ii) For studying the long-term financial position, one should examine the changes in fixed assets, long-term
liabilities and capital.
(iii) The next aspect to be studied in a comparative balance sheet is the profitability of the concern. The study of
increase or decrease in profit will help the interpreter to observe whether the profitability has improved or
not.
After studying various assets and liabilities, an opinion should be formed about the financial position of the
concern.

Preparatory steps

(i) While preparing the comparative balance sheet, the particulars for the financial factors are required
(ii) The second most important for the preparation of the comparative balance sheet is last year financial data
extracted from the balance sheet.
(iii) The next most important requirement to have an effective comparison with the last year financial data is
current year information extracted from the balance sheet of the firms.
(iv) After having been procured the financial data pertaining to various time periods, the comparative balance
sheet is ready to determine or identify the level of increase or decrease in the financial position of the firms
(v) To determine the level of increase or decrease in financial position, the percentage analysis to carried out
in between them.

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Illustration 1
From the following information, prepare comparative Balance sheet of Jyoti Ltd.

Solution
The first step we have to segregate the available information into two different categories viz. Assets and
Liabilities.

N. C = No change in the position during the two years

Interpretation
(i) The fixed assets volume got increased 20% from the year 2004 to 2005, amounted Rs. 12, 00, 000
(ii) Rs 9, 00, 000 worth of current assets decrease from the year 2004 to 2005 recorded 30%
(iii) The total volume of assets recorded 3% increase from the year 2004 to 2005
(iv) It obviously understood that 20% increase taken place on the reserves and surpluses
(v) It clearly evidenced that the current liabilities of the firm increased 10% from the year 2004 to 2005
(vi) The firm has not recorded any changes in the investments, equity share capital and long-term loans

Illustration 2
The following is the Balance Sheets of Ms Narayani Samal for the years 2006 and 2007. Prepare the comparative
Balance Sheet and study the financial position of the concern.

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Solution
Comparative Balance Sheet of Ms Narayani Samal for the year ending December 2006 and 2007

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Interpretation
(i) The comparative balance sheet of the company reveals that during 2007 there has been an increase in fixed
assets of Rs. 1, 10,000, i.e. 13.49%.
(ii) Long-term liabilities to outsiders have relatively increased by Rs.1, 50,000 and equity share capital has
increased by Rs 2, 00,000. This fact indicates that the policy of the company is to purchase fixed assets from
the long-term sources of finance.
(iii) The current assets have increased by Rs 152000 i.e. 26.67% and cash has increased by Rs 20,000. The
current liabilities have increased only by Rs 20000 i.e. 12.9%. This further confirms that the company has
used long-term finances even for the current assets resulting into an improvement in the liquidity position of
the company.
(iv) Reserves and surplus have decreased from Rs 330,000 to Rs 222,000 i.e. 32.73% which shows that the
company has utilized reserves and surplus for the payment of dividends to shareholders either in cash or by
way of bonus.
(v) The overall financial position of the company is satisfactory.

(b) Comparative Income Statement

This statement traditionally is known as Trading and Profit and Loss A/c. It provides the results of the operations of
a business. The important components of income statement are net sales, cost of goods sold, selling expenses,
office expenses, etc. It measures the:
 Change in the gross sales
 Change in the net sales
 Change in gross profit and net profit
 Change in operating profit

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  Change in operating expenses
 Change in the volume of non-operating income
 Change in the non-operating expenses
Like comparative balance sheet, income statement also has four columns. The first two columns are shown figures
of various items for two years. Third and fourth columns are used to show increase or decrease in figures in
absolute amount and percentages respectively. The analysis and interpretation of income statement involves the
following:
 The increase or decrease in sales should be compared with the increase or decrease in cost of goods sold.
 To study the operating profits
 The increase or decrease in net profit is calculated that will give an idea about the overall profitability of
the concern.
Illustration 3
The income statements of M/s. Flora Fabrics Ltd are given for the year ending 31st December 2006 and 2007.
Rearrange the figures in a comparative form and study the profitability of the concern

Solution:
Comparative income statement for the year ended 31st Dec 2006 and 2007

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Interpretation
(i) The comparative income statement given above, shows that there is an increase of net sales by 14.65% that
for the cost of goods sold by 11%. This has resulted in increase of gross profit by 19.4%.
(ii) Operating expenses have increased by 8%. The increase in gross profit is sufficient to cover the operating
expenses. There is also an increase in net profit after tax of Rs 38000 i.e. 42.22%.
It is concluded from the above analysis that there is sufficient progress in the performance of the company and the
overall profitability of the company is fine.
Illustration 4
From the following Profit and Loss Accounts and the Balance Sheets of Viku Seth Ltd. for the year ended 31st
December, 2004 and 2005, you are required to prepare a comparative income statement and a comparative
balance sheet.
Profit and Loss Account
For the year ending
(Rs. in ‘000)

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 Balance Sheet
as on 31st December
(Rs. in ‘000)

Solution:

VIKU SETH LTD

COMPARATIVE INCOME STATEMENT
For the Years 2004 and 2005
(Rs. in ‘000)

VIKU SETH LTD

COMPARATIVE BALANCE SHEET
For the Years ending
31st December, 2004 and 2005

(Rs. in ‘000)

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(B) Common-size Statements
Common Size Statement is a financial tool for studying the key changes and trends in the financial position and
operational result of a company. Here, each item in the statement is stated as a percentage of the aggregate, of
which that item is a part. Taking the example of a Balance Sheet, the total assets are taken as 100 and each item
in the asset-side is expressed as a percentage of the total assets. Similarly, the total liabilities are taken as 100
and each item in the liabilities side is expressed as a percentage of the total liabilities.

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In the common size income statement, each items of expenditure is shown as a percentage of the total sales. For
this reason common size statement is also known as ‘component percentage statement’ or ‘100% statements’. The
Common–size statements include:
(a) Common-size Balance sheet and
(b) Common-size Profit & Loss A/c
(a) Common size Balance Sheet
It is a statement where balance sheet items are expressed in the ratio of each asset to total assets and the ratio of
each liability is expressed in the ratio of total liabilities. It may be prepared in the following way.
(i) The total assets or liabilities are taken as 100
(ii) The individual assets are expressed as a percentage of total assets, i.e. 100 and different liabilities
are calculated in relation to total liabilities.
For example, if total assets are Rs. 10 lakhs and value of inventory is Rs 1, 00,000;then inventory will be 10% of
total assets [=10000*100/100000]
Illustration 5
The Balance Sheet of Anoop Private Limited and Bansal Private Limited on 31st December, 2007 are given below.
Prepare a common size Balance Sheet and interpret the results thereof.

Solution:
Common size Balance Sheet Anoop Pvt Ltd and Bansal Pvt Ltd
as on 31st December 2007

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Interpretation
(i) An analysis of pattern of financing of both the companies shows that Bansal Pvt Ltd is more traditionally
financed as compared to Anoop Pvt Ltd. The former company has depended more on its own funds as is
shown by balance sheet. Out of total investment, 74.01% of the funds are proprietary funds and outsiders
funds account only for 25.9%. In Anoop Pvt Ltd proprietors’ fund are 64.83% while the share of outsiders’
funds is 34.17% which shows that this company has depended more upon outsiders funds.
(ii) Both the companies are suffering from shortage of working capital. The percentage of current liabilities is
more than the percentage of current assets in both the companies.
(iii) A close look at the balance sheet shows that investments in fixed assets have been from working capital in
both the companies. In Anoop Pvt Ltd. fixed assets account for 94.52% of total assets while in Bansal Pvt
Ltd fixed assets account for 89.48%.
Thus, both the companies face working capital problem and immediate steps should be taken to issue more capital
or raise long term loans to improve working capital position.

(b) Common-size Profit & Loss Account

In the common size Profit & Loss Account or Income statement, the items of expenditure are shown as a
percentage of the net sales. If such a statement is prepared for successive periods, it shows the changes of the
respective percentages over a period of time.

Illustration 6

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Following are the income statements of a company for the year ending 31 st December 2006 and 2007. Prepare a
common-size income statement and interpret the results thereof.

Solution:
Common size Income Statement
for the year December 2006 and 2007

Interpretation
(i) The sale and gross profit have increased in absolute figures in 2007 as compared to 2006. But the
percentage of gross profit to sales has gone down in 2007.
(ii) The increase in cost of sales as a percentage of sales has brought the profitability from 34% to 27.14%.
(iii) Operating expenses in absolute figures have remained the same in both the years.
(iv) Net profit has decreased both in absolute figures and as a percentage in 2007 as compared to 2006.

Illustration 7

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From the following Profit and Loss Accounts and the Balance Sheets of Viku Seth Ltd. for the year ended 31 st
December, 2008 and 2009, you are required to prepare Common-size Income Statement.

VIKU SETH LTD

PROFIT AND LOSS ACCOUNT
(Rs. in ‘000)
Particulars 2008 2009 Particulars 2008 2009

Solution:
VIKU SETH LTD
COMMON-SIZE INCOME STATEMENT
For the years 2008 and 2009

(C) Trend Analysis

Trend analysis is also termed as ‘trend percentage’. It is used for the purpose of comparative study of financial
statements over a number of years. In case of trend analysis minimum three year financial data is a must. Out of
the periods under study, one year is taken as the base year and each item in this year is taken as 100. Trend
percentages are computed by dividing amount of each item in the statement of each remaining year with the
corresponding item in the base statement and the result is expressed in percentage.

The trend percentages being less than 100 clearly indicate a downward trend, whereas an upward trend is
indicated by the trend percentages being more than 100.

Procedure of Trend Analysis

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 (i) In case of trend analysis all the given years are arranged in an ascending order.
(ii) The first year is termed as the “base year” and all figure of the base year is taken as 100%.
(iii) Items in the subsequent years are compared with that of the base year.
(iv) In the percentage in the following years is above 100% it indicates an increase over the base year and if
the percentage is below the 100% it indicates a decrease over the base year.
(v) A trend analysis helps in analysing the financial performance of the business.
(vi) Trend analysis gives a better picture of the overall performance of the business.
(vii) A trend analysis indicates in which direction business is moving i.e. upward or downwards.
(viii) For trend analysis at least three year data is required.
Let us take the sales value, cost of sales, and PBDIT of Mahindra and Mahindra and understand the trend analysis.

Mahindra & Mahindra Ltd.

Items Mar-03 Mar-04 Mar-05 Mar-05
Total Incomes 4585.97 6030.37 8001.1 9569.74
Expense 4440.44 5689.85 7488.43 8712.64
PAT 145.53 340.52 512.67 857.1

Following steps are required to determine the trend percentage:

a) Select a base year: Let 2003 be the base year
b) Express the financial items of the succeeding years as a percentage of the base year number

Mahindra & Mahindra Ltd.

Items Mar-03 Mar-04 Mar-05 Mar-06
Total Incomes 100 31 74 109
Expense 100 28 69 96
PAT 100 134 252 489

The trend analysis shows that the sales in the latest year is 109% of the base year, whereas, the profit is much
higher (489%) of the base year. The above data can also be presented graphically.

Trend

600%
400%
200%
0%

1 2 3

Total Incomes Expense PAT

The trend analysis shows an overall decent growth in the profit too. However, to make the comparison more
meaningful, an inter-company comparison can be undertaken. Let us take one of the items viz. PAT of Mahindra
and compare it with that of Maruti. Following table and graphs show the comparison the recent five years. PAT of
Maruti sharply increased.

PAT Comparison
Items Mar-02 Mar-03 Mar-04 Mar-05 Mar-06
Mahindra & Mahindra
96.91 145.53 340.52 512.67 857.1
Ltd.

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 Maruti Udyog Ltd. 104.5 146.4 542.1 853.6 1189.1

Profit Comparison
1500
1000
500
0
2002 2003 2004 2005 2006

Mahindra & Mahindra Ltd. Maruti Udyog Ltd.

Precaution to be taken while preparing trend percentage statement

The trend percentage facilitates an efficient comparative study of the financial performance of a business enterprise
over a period of a time. While preparing a trend analysis the base year selected must be a representative of a
normal year. During inflationary periods the data over a period of time becomes incomparable unless the absolute
rupee is adjusted. Even though the trend percentage provide significant information, undue importance must not
be laid down on the percentage when there is small number in the base year in such a case even a slight variation
will be magnified by the percentage change. Trend analysis might also be useful to compare such trends with
similar trends in business generally and the industry concerned in particular.

Illustration 8
From the following data relating to Ms. Sekhar Suman for the years 2004 to 2007, calculate trend percentages
(taking 2004 as base year)

Solution
TREND PERCENTAGES MS. SEKHAR SUMAN
for the years 2004 to 2007

Interpretation
(i) On the whole, 2005 was a bad year but the recovery was made during 2006. In this year there is increase in
sales as well as profit.

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 (ii) The figures of 2005 when compared with 2004 reveal that the sales have come down by 5%. However, the
cost of goods sold and the expenses have decreased only by 1.8% and 3% respectively. This has resulted in
decrease in Net profit by 12%.
(iii) The position was recovered in 2006 and not only is the decline but also there positive growth in both 2006
and 2007. Moreover, the increase in profit by 31.3% (2006) and 50.6% (2007) is much more than the
increased in sales by 20% and 30% respectively. This shows major portion of cost of goods sold and
expenses is of fixed nature.

Illustration 9
From the following data relating to the assets side of Balance Sheet of ABC Ltd., for the period ended March 31,
2003 to March 31, 2006, calculate trend percentages and interpret the results thereof.

Balance Sheet of ABC Ltd

(Rs. in Lakhs)

Solution
Trend Percentages of ABC Ltd
(Rs. in lakhs)

Interpretation
(i) The assets have exhibited a continuous increasing trend over the period.
(ii) The current assets increased much faster than the fixed assets.

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 (iii) Sundry debtors and other current assets and buildings have shown higher growth.

Illustration 10
Four Years Profit & Loss Accounts are given below. You are required to make a trend analysis and comment on it.

Solution
Trend Percentages

Comments
Net Sales: In the year 2002, net sales amounted to Rs. 5000. In the year 2003, it came to Rs.6000, and in the
subsequent years like in 2004 and 2005, it increased to Rs. 7200 and Rs. 8640 respectively. As every company
wants to sustain and grow in the market, it has to increase its sales and thereby profit. Therefore by increasing net
sales every year the company was simultaneously increasing its profits also.

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Gross Margin: With the increasing net sales of the company, gross margin was also increasing. This shows that the
company is concentrating properly on gross margin.
Total Operating Expenses: Total operating Expenses comprises of Management and Sales Expenses. The total
operating expenses is in upward movement. It means that expenses are also increasing. The increase in these
expenses might be due to increase in amount of sales.
EBDIT: Earnings before depreciation, interest, and tax. This also showing the constant rise in trend as everything is
stable and attaining the steps of growth.
EBDT: In 2002, the interest was Rs.700, then it was Rs.980 in 2004 and further increase was Rs.1126 in 2005.
This states that the amount of interest the company is not fluctuating much.
EBT: In year 2002, it was Rs.200, and then it increased to Rs.400 in the year 2003, i.e. twice of the base year, in
2004 it reduced to Rs.380 and again rose to Rs.476 in 2005. We can say that it reduced in 2004 due to rise in
depreciation amount that year. As the depreciation was more, the amount after deducting depreciation resulted in
a fall in EBT that year.
Earnings after tax: it was fluctuating due to fluctuation in the rate of depreciation or due to change in current
assets.
Illustration 11
Four Years balance sheets of an organisation are given below. Make a trend analysis.

Solution

Trend Percentage Analysis of Balance Sheet

2002 2003 2004 2005
Particulars/Year
Amt % Amt % Amt % Amt %
1. Sources of Funds
Owned Funds
Share Capital 1000 100 520 52 1100 110 1000 100
Reserves 200 100 300 150 100 50 320 160
Net Worth 1200 100 820 68 1200 100 1320 120
Borrowed Funds
Debts 300 100 480 160 800 267 180 60
Capital Employed 1500 100 1300 87 2000 133 1500 100
2. Application of Funds
Assets
Fixed Assets 1250 100 1250 100 2000 160 1000 80
Acc Depn @ 20% 250 100 250 100 400 160 200 80

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 Written Down Value 1000 100 1000 100 1600 160 800 80
Current Assets 1000 100 800 80 1000 100 1400 140
Less: Current
500 100 500 100 600 120 700 140
Liabilities
Working Capital 500 100 300 60 400 80 700 140
Capital Employed 1500 100 1300 87 2000 133 1500 100

(D) Ratio analysis

Ratio analysis is an attempt to derive the financial health and profitability of business enterprises. It can be used
both in trend and static analysis. The main objectives of analyzing financial statement with the help of ratios are:
a) The analysis would enable the calculation of not only the present earning capacity of the business but would
also help in the estimation of the future earning capacity.
b) The analysis would help the management to find out the overall as well as the departmental efficiency of the
firm on the basis of the available financial information.
c) The short as well as the long-term solvency of the firm can be determined with the help of ration analysis.
d) Inter-firm comparison becomes easy with the help of ratios.

(E) Funds flow analysis

Fund flow analysis is the analysis of flow of funds. Though the balance sheet is known as the statement of sources
and application of funds, it does not disclose information on movement of funds, i.e. total funds raised and total
funds used during a year. This brings us to the serious limitation to this statement. To overcome this limitation of
the balance sheet, a statement called the ‘fund flow statement’ is prepared. It is a financial statement that shows
where from the firm got funds and what did the firm do with those funds, technically termed as ‘sources and
application of funds’. It is alternatively named as ‘statement of sources and application of funds’ ‘statement of
inflow and outflow of funds’, ‘where got where gone statement’ and so on. It is prepared to show the changes in
firm's financial position between two balance sheet dates. Therefore balance sheet of two consecutive years in
taken to analyze the change.
(F) Cash flow analysis
Cash Flow Statement is prepared to study the changes in cash, or to show impact of various transactions on the
cash. In short, it is a statement, which is prepared to show the flow of cash in the business during a particular
period. It thus, tells about the changes in cash position of a business. The changes may be related either with the
cash receipts or cash payments or disbursements of cash. The objectives of cash flow statement are:
(i) To ascertain the specific sources (i.e., operating/investing/financing activities) of cash and cash equivalents
generated by an enterprise.
(ii) To ascertain the specific uses (ie. operating/investing/ financing activities) of cash and cash equivalents
used by an enterprise.
(iii) To ascertain the net change in cash and cash equivalents (sources minus uses of cash and cash equivalents)
between the date of two Balance Sheets.
Limitation of Financial Statement Analysis
Although financial statement analysis is a powerful mechanism of determining financial strength and weakness of a
firm, it has its own limitations which are discussed below:
(i) Limitations of Financial Statements: Financial Statements are the basis for financial statements analysis.
Hence, the limitations of financial statements, such as; influence of personal prejudice on accounting
concepts and conventions, disclosure of only monetary events, etc., are also the limitations of financial
statements analysis.
(ii) Ignores the Price-Level Changes: Financial analysis fails to disclose current worth of the enterprise, since it is
based on financial statements, which are merely a record of historical cost.
(iii) Not Free from Bias: In many situations, the accountant has to make a choice out of various alternatives
available, e.g., choice in the method of depreciation, choice in the method of inventory valuation. Since, the
subjectivity is interest in personal judgment; the financial statements are therefore not free from bias. As a
result, financial analysis also cannot be said to be free from bias.
(iv) Window Dressing: The term window dressing means presentation of account that conceals vital facts and
showing better position than what it actually is. On account of such a situation, financial analysis may not be
a definite indicator of good or bad management.
(v) Only a means: Financial only a means and not an end in itself. The analyst has to make interpretation and
draw his own conclusion. Different people may interpret the same analysis in different ways.

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Questions

Theoretical
1. What is financial statement analysis? State the tools which are commonly used for analysing and
interpreting financial statements.
2. Justify the need for analysis and interpretation of financial statements.
3. List out the objectives of the financial statement analysis.
4. Explain the main techniques of financial statement analysis.
5. Briefly explain the parties interested in analysis of financial statements.
6. Write a brief notes on comparative statement, common size statement and trend analysis.
7. “Financial statement analysis is the solution to the problem of inefficiency of a company”- Comment.
8. What is a common size balance sheet? What is the purpose of common size analysis?
9. What is a comparative income statement? Explain the steps involved in the process of comparative
balance sheet.
10. Explain the steps involved in the process of comparative statement of balance sheet.
11. Write brief note on the trend analysis
Practical Questions

1. Prepare Comparative income statement from the following information for the year’s ended
March 31, 2003 and 2004.
Particulars 2003(Rs.) 2004(Rs.)

Net Sales 8,00,000 10,00,000

Cost of Goods Sold 60% of sales 60% of sales
Indirect Expenses 10% of Gross profit 10% of Gross Profit
Income Tax rate 50% 60%

2. Following is the Balance Sheet of Marico.

Balance sheet of Marico
(Rs. in crores)
Mar- Mar- Mar-
  05 04 05 Mar-04
Equity Share Capital 58 29 Fixed Assets 88 82
Reserves and surplus 161 151 Capital W.I.P 12 8
Long term Loans 52 9 Investments 29 14
Current Liabilities 109 94 Inventories 112 95
Provisions 15 12 Debtors 35 33
Cash and Bank
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      Balances 18
      Other Current Assets 101 40
  395 296   395 296

Required to prepare:
(i) Common size and comparative balance sheet
(ii) Compare liquidity and solvency of HLL and Marico

3. Following is balance sheet of HLL

Balance sheet of HLL
(Rs. in crores)
200 200 200 200
  4 3   4 3
Equity Share Capital 220 220 Fixed Assets 1427 1296
Reserves and surplus 1873 1919 Capital W.I.P 94 74
Long term Loans 1471 1608 Investments 2328 2575
Current Liabilities 2731 2656 Inventories 1470 1393
Provisions 1222 1311 Debtors 489 471
Cash and Bank
    Balances 699 806

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     Other Current Assets 1008 1099
  7516 7714 7516 7714

You are required to prepare:

(i) Common size balance sheet
(ii) Comparative balance sheet
(iii) Comment on the liquidity and solvency position
4. The following are the balance sheets of Devi Co. Ltd at the end of 2002 and 2003. Prepare a Comparative
Balance Sheet and study the financial position of the concern.

5. From the following table, prepare the common size statement and analyse the results thereof

6. From the following particulars extracted from Profit & Loss A/c of Toofani Ltd., you are required to
calculate trend percentages

7. The accompanying balance sheet and profit and loss account related to Sumana Pvt. Ltd. Convert these
into Common Size Statements.
Previous Year = 2009 Current Year= 2010
Rs.in thousands

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 Income Statement for the year ended
Rs.in thousands

8. The following are the Balance Sheets of Ms Anjani Pattaniak for the year 2006 and 2007. Discuss the
financial position of the company in two years with the help of common size Balance Sheet.

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