Financial Statements Analysis and

Module 2 VI Sem [Link]

Interpretation
Syllabus
Introduction – Meaning and Nature of financial statements - Limitations of financial
statements - Essentials of a good financial statement. Analysis and interpretations- Meaning
and definition of Financial of analysis, types of analysis, Techniques of Financial Analysis-
Comparative Statements, Common Size Statements and Trend Analysis - Problems.

Introduction to Financial Statements: The ultimate objective or result of the financial

accounting is communicating the true and fair financial position to the needy people in the
prescribed manner known as Financial Statements, It includes preparation of Income
Statements and Balance Sheet. It is intended to convey the profitability position and the overall
financial soundness of the concern. However only the financial statements like Income
Statements and Balance Sheet in its actual form sometime cannot convey the true and fair
financial position. It needs to be analysed as per the requirement of the circumstances and
objectives of the needy people and it needs the different ways of presentation for different
people so that the same facts and figures can serve different objectives. In this regard, it is
essential to understand the concept of Financial Statement Analysis.

Meaning of Financial Statements: Financial statements are formal records that present the
financial activities and position of a business, organization, or individual over a specific period.
They provide a summary of financial performance, cash flows, and financial position, helping
stakeholders make informed decisions.

Financial statements are the essential documents of business. They are the outputs of financial
accounting. They are the final products of the accounting process. They are statements
containing financial information of a business enterprise. The basic purpose of preparing
financial statements is to convey information about financial position of the enterprise to
owners, creditors and the investors.

Objectives of Financial Statements: The main objective of financial statements is to

provide information about the financial position and performance of an enterprise that is useful
to users in making decisions.

The other objectives are summarized below:

1. To provide information about assets and liabilities of a firm.
2. To provide useful information to various parties interested in financial statements.
3. To present true and fair view of the business.
4. To estimate the earning capacity of the enterprise.
5. To determine the debt capacity of the concern.
6. To decide about the future prospects of the business.

Thus, the ultimate objective of financial statements is to get better insight about the financial
strengths and weakness of the firm.
Nature of Financial Statements: The following characteristics of financial statements
indicate their nature:

1. Recorded Facts: The term recorded facts refers to the data drawn from accounting records.
Only those facts which have been recorded in the books are shown in the financial statements.

2. Accounting Principles: In the preparation of financial statements, certain accounting

principles, concepts and conventions are followed. For example: The principle of cost price or
market price whichever is less is followed for valuation of stock.

3. Assumptions: Business transactions are recorded on certain assumptions. For example:

In preparing financial statements, the accountants make many assumptions like that the value
of money remains constant, going concern concept etc.

4. Personal Judgment: The financial statements are affected by the personal judgment of
accountants. For example. The method of stock valuation, method of depreciation etc. depend
on the personal judgment of the accountant. The accountant can select one of the available
methods of stock valuation, depreciation etc.

Essential of Financial Statements:

The financial statements should possess the following essential qualities:

1. Understand ability: Financial statements should be easily understandable by users. For

this, the information contained in these statements should be clear and simple.

2. Relevance: The financial statements must contain only relevant information. Then only the
users can evaluate past, present and future events and can take wise decisions.

3. Reliability and Accuracy: Financial statement should disclose information in such a way
that the users can compare the current year's progress with that of previous year. Users must
also be able to compare the financial performance of reporting company with that of other
companies.

4. Comparability: Financial statements should disclose information in such a way that the
users can compare the current year's progress with that of previous year. Users must also be
able to compare the financial performance of reporting company with that of other companies.

5. Completeness: The information contained in the financial statements should be complete in

all aspects. This means all information should be shown in this statements.

6. Timeliness: The financial statements should be prepared within a reasonable time after
the accounting period is over. If the statements are not prepared and presented in time, they
cannot be properly used.

Importance of Financial Statements or Users of Financial Statements

The following are the uses of financial statements to different parties are:
1. Importance for Management (Owners)
2. Importance for Investors
3. Importance for Trade Creditors or Suppliers
4. Importance for banks
5. Importance for customers
6. Importance for employees
7. Importance for Govt. and their agencies.
8. Importance for Public.
9. Importance for trade Unions

Meaning of Analysis and Interpretation of Financial Statements

The term "analysis" can be understood as the process of splitting the facts or data found in
the financial statements into simple elements.

The term "interpretation" can be understood as the explanation of the meaning and
significance of the financial data: so simplified with a view to throw light on the profitability
and financial position of an enterprise.

In the words of Metcalf and Titard, "Analysing financial statements is a process of evaluating
the relationship between component parts of a financial statement to obtain a better
understanding of a firm's position and performance."

Types of Financial Statement Analysis

1. On the basis of modes operating

a) Horizontal Analysis: Financial analysis is done for number of years, it is known

as horizontal analysis. Such analysis set a trend wherein the figures of various years
are compared with base year.
b) Vertical Analysis: Analysis is made for data covering one year's periods it is
known as vertical analysis. Example: Ratios and Common size financial statement

2. On the basin of material used

a) External Analysis: Financial statements analysis is made by outsiders who have

no access to the books of accounts they have depend on the published accounts.
Example: Shareholders, Creditors, Government agencies etc.

b) Internal Analysis: Financial statements analysis is made by internal parties who

have access to the books of accounts such as management, employees etc.

Techniques of Financial Analysis:

1. Comparative Statements – Comparative Income statements and Comparative Balance

sheet
2. Common Size Statements- Common-size income statement and common size Balance
sheet
3. Trend Analysis
4. Ratio Analysis
 5. Fund flow analysis
6. Cash flow Analysis

Limitations of financial statements

1. Historical Cost Basis: Financial statements are primarily based on historical costs,
meaning they reflect the original purchase price of assets, not their current market value,
which can be misleading in a changing economic environment.
2. Lack of Non-Financial Information: Financial statements primarily focus on
quantitative financial data, omitting important qualitative aspects like customer
satisfaction, employee morale, and environmental impact, leading to an incomplete
picture of a company's performance.
3. Subjectivity and Estimates: Accounting often requires estimations for certain items
like depreciation and bad debts, which can introduce subjectivity and potential for
manipulation by management.
4. Intangible Assets: Many intangible assets like brand value, intellectual property, and
goodwill are not easily quantifiable and may not be fully reflected in financial
statements, potentially undervaluing a company.
5. Accounting Policy Variations: Different companies may use different accounting
policies, making it difficult to compare financial statements across different
organizations.
6. Potential for Fraud: Management may intentionally manipulate financial information
to present a more favourable picture, which can be difficult to detect without proper
auditing procedures.
7. Focus on Past Performance: Financial statements primarily reflect past performance
and may not accurately predict future trends or potential risks in a dynamic business
environment.
8. Limited Future Projections: Financial statements typically do not include detailed
future projections or forecasts, which are crucial for strategic decision-making.
9. Dependence on Management Judgment: The preparation of financial statements
involves significant management judgment, which could lead to biases or
inconsistencies in reporting.

Practical Problems on Comparative Income statement

[Link] the following income Statement of Putamen Ltd. on 2021 and ZAZ2. Prepare
comparative income statement and comment.
Income Statement 2021 and 2022
Particulars 2021 2022
Net sales 10,00,000 20,00,000
Cost of goods sold 80% on sales 75% on Sales
Operating expenses 1,00,000 20,000
interest payable 10% of operating exp. 10% of Operating expense
Tax 30% 30%
2. 2018 F
3. 2018 F

4. 2017
5. 2016

6. 2015 F

7. 2014 F
Practical Problems on Comparative Balance sheet

1.2018 R

2.
2.2017
 3. 2016F

4. From the following Balance Sheet of Kavana Ltd. for the year 202 j and ZAZZ" Prepare
Comparative Balance Sheet and Comment. (QP 2023 R)
Balance Sheet of Kavana Ltd.
Liabilities 2021 ₹ 2022 ₹ Assets 2021 ₹ 2022 ₹
Equity share capital 2,00,000 3,00,000 Land and 2,00,000 2,10,000
10% preference 2,00,000 1,00,000 Building
share capital Plant 2,00,000 2,40,000
Reserve fund 50,000 40,000 Furniture 50,000 70,000
P&L A/c 20,000 60,000 Investment 40,000 70,000
12% Debenture 1,30,000 2,00,000 Stock 60,000 40,000
Creditors 20,000 50,000 B/R 40,000 60,000
B/P 60,000 25,000 Debtors 60,000 50,000
Bank overdraft 20,000 25,000 Cash in hand 50,000 60,000

7,00,000 8,00,000 7,00,000 8,00,000

5. The Balance Sheets of Sathynarayana and Company tor 2022 and 2023 ate given. You are
required to prepare Comparative Balance Sheet and comment the result. (2023 F)
Liabilities 2022 ₹ 2023 ₹ Assets 2022 ₹ 2023 ₹
 Ordinary share 1,50,000 3,00,000 Building 2,00,000 4,00,000
capital Machinery 50,000 90,000
8% preference share 1,25,000 2,25,000 Furniture - 10,000
capital Investment 100,000 125,000
General Reserve 100,000 125,000 Debtors 20,000 75,000
P&L A/c 50,000 75,000 B/R 12,500 37,500
Secured loan 50,000 125,000 Cash 5,000 25,000
Creditors 20,000 50,000 Stock 1,25,500 1,62,500
B/P 4,000 20,000
Provision for tax 1,000 5,000
5,00,000 925,000 5,00,000 925,000

Practical Problems on Common Size Income Statement

1. From the following prepare Common Size income Statement.

Particula Diteep Co Shitii Co
Sale 11,50,000 12,50,000
Cost of goods sold 6,00,000 6,25,000
Operating expenses
Administrative 1,05,000 90,000
Selling 90,000 1,25,000
Non-operating expenses
Interest paid 70,000 60,000
Income tax 50% 50%

Practical Problems on Common Size Balance sheet

1.2018F
2. 2017

You are required to prepare common size Balance Sheet and comment.

3. 2016 R
4. 2015 F
 5. 2014 F

[Link] are the Balance Sheets of Rama Ltd. and Lakshmana Ltd. as on 31-3-2022.
(2022 F+R)
Liabilities Rama Lakshma Lakshma Rama
Ltd. na Ltd. na Ltd. Ltd.
Equity share capital 4,00,000 10,00,000 Land and 6,00,000 12,50,000
10% preference buildings
share capital 2,00,000 3,00,000 Plant and 3,60,000 8,40,000
5% debentures 2,00,000 2,00,000 machinery
Reserves and 2,00,000 2,40,000 Stock 3,00,000 4,00,000
 surplus Sundry 2,00,000 2,70,000
Provision for 1,00,000 1,40,000 debtors
taxation 5,00,000 8,20,000 Cash in hand 1,40,000 40,000
Sundry creditors --- 1,00,000
Bank overdraft
16,00,000 28,00,000 16,00,000 28,00,000
You are required to prepare common size Balance Sheet and comment.

[Link] extracts of Balance Sheets of Ram Ltd. as on 31-3-2018 and 31-3-2019 are given
below: Prepare Common-size Balance Sheet and comment. (2020 F+R)
Particulars As on 31-3-2018 As on 31-3-2019
1).Equity and Liabilities
a. Shareholders' funds
Share capital 18,00,000 24,00,000
Reserves and surplus 6,00,000 8,00,000
2) Non-current Liabilities:
Long-term borrowing 2,40,000 2,00,000
3) Current Liabilities: 5,00,000
Trade payables 2,70,000 1,00,000
Other current liabilities 90,000
Total 30,00,000 40,00,000
2) Assets
1) Non-current assets
Fixed assets
i) Tangible assets 21,60,000 30,00,000
ii) Intangible assets 75,000 60,000
2) Current assets:
Inventories 3,00,000 4,00,000
Trade receivables 3,60,000 3,20,000
Cash and cash equivalents 1,05,000 2,20,000
Total 30,00,000 40,00,000

Practical Problems on trend Percentage

[Link] trend percentages from the following figures of Ramya Enterprises taking 2018-
19 as base. (QP 2022 F+R)
Particulars 2018 19 2019-20 2020-21 2021 22
Net sales 4,00,000 3,60,000 4,80,000 6,00,000
Less: Cost of goods sold 2,40,000 2,40,000 2,80,000 3,20,000
Gross profit 1,60,000 1,20,000 2,00,000 2,80,000
Less: Operating expenses 40,000 40,000 60,000 80,000
Net operating profit 1,20,000 80,000 1,40,000 2,00,000
Less Income tax 60,000 40,000 70,000 1,00,000
Profit after tax 60,000 40,000 70,000 1,00,000

2. Calculate the trend percentages from the following figures of Kalpana Enterprises taking
2016 as the Base. (Qp 2021)
Particulars 2016 2017 2019 2019
Net sales 1,00,000 90,000 120,000 150,000
Less: Cost of goods sold 60,000 60,000 70,000 80,000
 Gross profit 40,000 30,000 50,000 70,000
Less: Operating expenses 10,000 10,000 15,000 20,000
Net operating profit 30,000 20,000 35,000 50,000
Less Income tax 15,000 10,000 17,500 25,000
Profit after tax 15,000 10,000 17,500 25,000
3. From the following figures of Rock Ltd. calculate the Trend Percentages for the years 2015
to 2019 taking 2014 as the base. (2020 F+R)
Items 2014 2015 2016 2017 2018 2019
Sales 1,880 2,350 2,820 3,384 3,948 4,230
COGS 1,020 1,122 1,530 1,836 2,091 2,142
Operating 420 483 546 693 777 861
exp.
4. From the following information compute trend ratios. Use 2005 as base. (Amount in lakhs
of rupees of the year ended) (2018 R)
Particulars 2005 2006 2007 2008
Net Sates 400 380 480 520
Cost of goods sold 240 236 280 290
Gross Profit 160 144 200 230
operating expenses 40 38 44 48
Net operating prof 120 106 156 182

5.2017 R

6.2016