AHSEC - 12: Financial Statement Analysis Important Notes for MAY' 2021 Exam | Revised and Reduced Syllabus

Class 12 Accountancy Notes

Unit – 8: Analysis of Financial Statements 

Unit – 8: Analysis of Financial Statements FOR 2021 EXAM

Q.1. What is financial analysis? What are its significance and Limitations (5 Points)? 2012, 2013, 2016

Ans: Financial Statement Analysis: It is the process of identifying the financial strength and weakness of a firm from the available accounting information and financial statements. The analysis is done by properly establishing the relationship between the items of balance sheet and profit and loss account.

In the words of Myer “Financial Statement analysis is largely a study of relationship among the various financial factors in a business, as disclosed by a single set of statements, and a study of trends of these factors, as shown in a series of statements.”

In simple words, analysis of financial statement is a process of division, establishing relationship between various items of financial statements and interpreting the result thereof to understand the working and financial position of a business.

Objectives (Purposes) and significance of Financial Statement analysis:                                2018

Financial analysis serves the following purposes and that brings out the significance of such analysis:

a)      To judge the financial health of the company: The main objective of the financial analysis is to determine the financial strength and weakness of the company. It is done by properly establishing the relationship between the various items of balance sheet and profit and loss account.

b)      To judge the earnings performance of the company: Potential investors are primarily interested in earning efficiency of the company and its dividend paying capacity. The analysis and interpretation is done with a view to ascertain the company’s position in this regard.

c)       To judge the Managerial efficiency: The financial analysis helps to pinpoint the areas wherein the managers have shown better efficiency and the areas of inefficiency. Any favourable and unfavourable variations can be identified and reasons thereof can be ascertained to pinpoint weak areas.

d)      Inter-firm and intra-firm Comparison: Inter-firm and intra-firm comparison becomes easy with the help of financial analysis. It helps in assessing own performance as well as that of others.

e)      Understandable: It simplifies and summarises the accounting figures to make them understandable to the users. It gives a brief idea about the whole story of changes in the financial condition of a business.

Limitations of financial analysis:

Financial analysis suffers from various limitations which are given below:

a)      Historical Analysis: Financial statements are historical in nature. Financial analysis is simply a rearrangement of historical data. It analysed what has happened till date but it does not reflect the future.

b)      Ignores Price Level Changes: Change is price level affects the comparability of financial statements. A change in the price level makes financial analysis of different accounting years invalid because accounting records ignores change in value of money.

c)       Qualitative aspect Ignored: Since the financial statements are based on quantitative aspects only, the quality aspect such as quality of management, quality of labour force etc., are ignored while analysis of such statements. Under such circumstances, the conclusions derived from financial analysis would be misleading.

d)      Suffers from the Limitations of financial statements: Since analysis of financial statements is based on the information given in the financial statements, it suffers from all such limitations from which the financial statements suffer.

e)      Not free from Bias: Financial statements are largely affected by the personal judgment of the accountant in selecting accounting policies, therefore financial analysis is also not free from this limitations. If the personal judgement of the analyst is biased, then the conclusion drawn will be misleading.

Q.2. What are various types of Financial Analysis?                          2012

Ans: Types of financial Statement analysis:

The main objective of financial analysis to determine the financial health of a business enterprise. The analysis may be of the following types:

a)      External analysis: This analysis is performed by outside parties such as trade creditors, investors, suppliers of long term debt etc.

b)      Internal analysis: This analysis is performed by the corporate finance and accounting department and is more detailed than external analysis.

c)       Horizontal analysis: This analysis compares the financial statements viz., profit and loss accounts and balance sheet of previous year along with the current year. Comparative statements are examples of this analysis.

d)      Vertical analysis: This analysis converts each element of the information into a percentage of the total amount of statement so as to establish relationship with other components of the same statement. Common size statements are examples of this analysis.

e)      Trend analysis: This analysis compares ratios of different components of the financial statements related to different period to those of a base year.

Q.3. Who are the parties interested in financial analysis?

Ans: Users of accounting information may be categorised into (1) Internal Users; and (2) External Users.

(1) Internal Users:

(i)         Owners: Owners are always interested in knowing the profitability and financial strength of the company.

(ii)       Management: It helps them in decision making as well as in controlling and self evaluation.

(iii)      Employees and Workers: Employees and workers are entitled to bonus at the year end besides the salary and wages which is directly linked with the profits of the enterprise.

(2) External Users:

(i)     Banks and Financial Institutions: Banks and Financial Institutions provide loans to the businesses. They watch the performance of the business to ensure the safety and recovery of the loan advanced.

(ii)   Investors and Potential Investors: Investors uses financial statements to assess the earning capacity of the enterprise and ensure the safety of their investment.

(iii) Creditors: Creditors before granting credit wants to satisfy themselves about the creditworthiness of the business.

(iv) Government authorities: The government makes use of financial statements to compile national income accounts and other information.

(v)   Consumers: Customers have an interest in information about the continuance of an enterprise.

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ALSO READ (AHSEC ASSAM BOARD CLASS 12):

1. AHSEC CLASS 12 ACCOUNTANCY CHAPTERWISE NOTES

2. AHSEC CLASS 12 ACCOUNTANCY IMPORTANT QUESTION (THEORY)

3. AHSEC CLASS 12 ACCOUNTANCY IMPORTANT QUESTION BANK (PRACTICAL)

4. AHSEC CLASS 12 ACCOUNTANCY PAST EXAM PAPERS (FROM 2012 TILL DATE)

5. AHSEC CLASS 12 ACCOUNTANCY SOLVED QUESTION PAPERS (FROM 2012 TILL DATE)

6. AHSEC CLASS 12 ACCOUNTANCY CHAPTERWISE MCQS

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Q.4. What are various tools of Financial Analysis? Explain them with their respective merits and limitations.

Ans: Tools of financial Statement analysis: The main objective of financial analysis to determine the financial health of a business enterprise. The analysis may be done with the help of following tools

a)      Comparative balance sheets and income statements                              2016, 2018, 2019

b)      Common size statements,                                   2015, 2017, 2018, 2020

c)       Trend analysis,                                                          2014, 2017

d)      Ratio analysis,

e)      Cash flow analysis.

1. 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. 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’.

Merits of Comparative Financial Statements:

a)      Comparison of financial statements helps to identify the size and direction of changes in financial position of an enterprise.

b)      These statements help to ascertain the weakness and soundness about liquidity, profitability and solvency of an enterprise.

c)       These statements help the management in making forecasts for the future.

Demerits of Comparative Financial Statements:

a)      Inter-firm comparison may be misleading if the firms are not of the same age and size, follow different accounting policies.

b)      Inter-period comparison will also be misleading if there is frequent changes in accounting policies.

c)       Since Comparative statements are based on financial statements, therefore qualitative elements of the business are ignored.

b) Common Size Statements: Common size statement is a statement in which amounts of individual item of balance sheet and profit and loss account for one or more years are expressed in terms of percentage of a common base. The common base can be net sales in the case of profit and loss account and total of balance sheet for the balance sheet.

Merits of Common Size Statements:

(i)        A common size statement facilitates both types of analysis, horizontal as well as vertical. It allows both comparisons across the years and also each individual item as shown in financial statements.

(ii)      It helps in finding trend of percentage share of each asset in total assets and percentage share of each liability in total liabilities.

(iii)    These statements help the management in making forecasts for the future.

Demerits of Common Size Statements:

(i)        If there is no identical head of accounts, then inter-firm comparison will be difficult.

(ii)      Since Common size statements are based on financial statements, therefore qualitative elements of the business are ignored.

(iii)    Changes in price level over the years are ignored in financial statements. It makes the common size statement misleading.

(iv)    If there is frequent changes in accounting policies, then the common size statements becomes useless.

c) Trend Analysis: Trend analysis is an important tool of horizontal financial analysis. This is helpful in making a comparative study of the financial statements over several years. Under this method trend percentages are calculated for each item of the financial statements taking the figure of base year as 100. Normally the starting year is taken as the base year. The trend percentages show the relationship of each item with its preceding year’s percentages.

Merits of Trend analysis:

(i)        Trend percentages can be presented in the form of Index Numbers showing relative change in the financial statements during a certain period.

(ii)      Trend analysis will exhibit the direction to which the concern is proceeding.

(iii)    The trend ratio may be compared with the industry, in order to know the strong or weak points of a concern.

Demerits of Common Size Statements:

(i)     These are calculated only for major items instead of calculating for all items in the financial statements.

(ii)   Trend values will also be misleading if there is frequent changes in accounting policies.

(iii) Since trend percentage are based on financial statements, therefore qualitative elements of the business are ignored.

Q.5. What is window dressing of financial statements? How does it affect the analysis of financial statements?

Ans: Window dressing is a technique used by the company to manipulate financial statements and present the position of the company is favourable manner to the various users of financial statements. This is a dishonest technique and used to mislead the investors.

Ways of window dressing:

a) Creation of secret reserves by charging more depreciation or more provision for bad debt or overstatement of liabilities.

b) Under valuation of opening inventories and over valuation of closing inventories to show high profits.

c) Postponement of payment to creditors to show sound cash position at the end of accounting year.

Analysis of financial statements is affected from the limitation of window dressing as companies hide some important vital information or show items at incorrect value to show better profitability and financial Position of the business. This leads in inappropriate analysis of data and presents a misguided information to the investors