Meaning and objectives of analysis
Financial statement analysis is the study of relationships among items in the financial statements to judge a company's financial position and performance.
- To assess earning capacity (profitability).
- To assess short-term solvency (liquidity) and long-term solvency.
- To make inter-firm and intra-firm comparisons (with others and over years).
- To help forecast and plan budgets.
- To find strengths and weak spots for managers, investors and lenders.
Tools: comparative statements, common-size statements, ratio analysis, cash flow analysis.
Limitations of financial analysis
- Based on historical data; the future may differ.
- Ignores price level changes (inflation).
- Qualitative factors (staff skill, brand, relations) are left out.
- Different accounting policies (depreciation, stock valuation) reduce comparability.
- Window dressing can make statements look better than they are.
- Personal judgement of the analyst affects conclusions.
Comparative statements
A comparative statement shows items for two or more years side by side, with columns:
- Previous year (₹)
- Current year (₹)
- Absolute change = Current − Previous
- Percentage change = Absolute change ÷ Previous year × 100
It is also called horizontal analysis. Prepared for both the Balance Sheet and the Statement of Profit and Loss. Follow Schedule III order.
Common-size statements
A common-size statement shows each item as a percentage of a common base:
- Statement of Profit and Loss: base = Revenue from operations = 100.
- Balance Sheet: base = Total assets (or total equity and liabilities) = 100.
It is vertical analysis. Columns: amounts for each year and % of base for each year. It makes firms of different sizes comparable.
Key formulas and definitions
- Absolute change = Current year − Previous year
- % change = Absolute change ÷ Previous year × 100
- Common-size % (P&L) = Item ÷ Revenue from operations × 100
- Common-size % (Balance Sheet) = Item ÷ Total assets × 100
- Profit before tax = Total income − Expenses (for the statement layout)
Worked examples
1. Revenue: Year 1 ₹10,00,000, Year 2 ₹12,50,000. Change and % change?
Absolute ₹2,50,000; % = 2,50,000 ÷ 10,00,000 × 100 = 25%.
2. Expenses: Year 1 ₹6,00,000, Year 2 ₹7,50,000. % change?
1,50,000 ÷ 6,00,000 × 100 = 25%.
3. Other income falls from ₹40,000 to ₹30,000. % change?
−10,000 ÷ 40,000 × 100 = −25%.
4. Revenue ₹12,50,000; expenses ₹7,50,000; tax ₹1,50,000. Common-size % of each and of profit.
Revenue 100%; expenses 60%; PBT 5,00,000 = 40%; tax 12%; profit 3,50,000 = 28%.
5. Total assets ₹20,00,000: non-current assets ₹12,00,000; current assets ₹8,00,000. Common-size?
Non-current 60%; current 40%.
6. Two firms: A's profit ₹2 lakh on revenue ₹10 lakh; B's ₹5 lakh on ₹50 lakh. Which is more profitable?
Common-size: A 20%, B 10%. A earns more per rupee of revenue, though B's profit is bigger.
Common mistakes
- Dividing the change by the current year instead of the previous year.
- Using total income instead of revenue from operations as the common-size base.
- Forgetting the minus sign when an item falls.
- Thinking a bigger rupee profit always means better performance; compare percentages.