Short Answer Type Question:
Q.1 List the techniques of Financial Statement Analysis.
ANSWER: The following are the commonly used techniques of Financial Statement analysis :
1. Comparative Financial Statements
2. Common Size Financial Statements
3. Trend Analysis
4. Ratio Analysis
5. Cash Flow Statement
6. Fund Flow Statement
The above listed techniques can be classified on the following basis:
A. On the basis of Comparison
1. Inter-firm Comparison
a) Comparative Statement (Balance Sheet, Profit and Loss Account)
b) Common size Statement (of the same period)
c) Ratio of two or more Competitive Firms (of the same period)
d) Cash Flow Statement of two or more Competitive firms
e) Polygon, Bar Diagram
2. Intra-firm Comparison
a) Comparative Statement (Balance Sheet, Profit and Loss Account)
b) Common size Statement (of the same period)
c) Ratio of two or more Competitive Firms (of the same period)
d) Cash Flow Statement of two or more Competitive firms
e) Polygon, Bar Diagram
3. Horizontal Comparison
4. Vertical Comparison
B. On the basis of Time
1. Inter-period Comparison
a) Comparative statement (two or more periods)
b) Cash Flow statement (two or more period) etc.
2. Cross Sectional (Intra-period) Comparison
a) Common size statement
b) Ratio Analysis
C. Horizontal Analysis
1. Time series
2. Bar Diagram
3. Polygon
4. Comparative statement
5. Ratio Analysis
D. Vertical Analysis
1. Common size statement
2. Pie Diagram
Q.2 Distinguish between Vertical and Horizontal Analysis of financial data.
ANSWER:
| Basis of Difference | Horizontal Analysis | Vertical Analysis |
| Meaning | It refers to the comparison of an item of the financial statement of one period or periods to its corresponding item of the base accounting period. | It refers to the comparison of itemitems of the financial statement to the common item of the same accounting period. |
| Purpose | Its purpose is to determine the change in an item during an accounting period. The change in the item is expressed either in absolute figures or in percentage or in both terms. | Its purpose is to determine the proportion of item/items to the common item of the same accounting period. The change in the item is expressed either in ratio or in percentage terms. |
| Usefulness | It indicates growth or decline of the item. | It helps in predicting and determining the future relative proportion of an item to the common item. |
Q.3 State the meaning of Analysis and Interpretation.
ANSWER: Analysis and Interpretation refers to a systematic and critical examination of the financial statements. It not only establishes cause and effect relationship among the various items of the financial statements but also presents the financial data in a proper manner. The main purpose of Analysis and Interpretation is to present the financial data in such a manner that is easily understandable and self explanatory. This not only helps the accounting users to assess the financial performance of the business over a period of time but also enables them in decision making and policy and financial designing process.
| Country Man Ltd Comparative statement as on March 31, 2010 and 2011 | ||||
| Particular | 2009–10 | 2010–11 | AbsoluteChange | % Change |
| Sales | 1,00,000 | 1,50,000 | 50,000 | 50 |
| Less: Cost of Goods Sold | 60,000 | 78,000 | 18,000 | 30 |
| Gross Profit | 40,000 | 72,000 | 32,000 | 80 |
| Less: Operating Expenses: | ||||
| Office and Administrative Exp. | 8,000 | 10,000 | 2,000 | 25 |
| Selling and Distribution Exp. | 5,000 | 6,000 | 1,000 | 20 |
| Operating Profit | 27,000 | 56,000 | 29,000 | 107.4 |
| Add: Other Income | 3,000 | 4,800 | 1,800 | 60 |
| Less: Non-operating Expenses | 4,000 | 4,800 | 800 | 20 |
| Profit Before Interest and Tax | 26,000 | 56,000 | 30,000 | 115.38 |
| Interest | 2,000 | 1,800 | (200) | (10) |
| Profit before Tax | 24,000 | 54,200 | 30,200 | 125.83 |
| Less: 50% Income Tax | 12,000 | 27,100 | 15,100 | 125.83 |
| 12,000 | 27,100 | 15,100 | 125.83 |
Interpretation:
1. Sales of the company have increased by 50% during the year 2010−11 whereas the cost of goods sold has also increased but at a lesser rate. From this, we can infer that the company has followed an efficient sales strategy consequent of which the gross profit of the company has increased by 80% compared to the previous year (2009-10).
2. In 2010−11, operating expenses have also increased but on the contrary operating profit has increased at a higher rate than the rate of operating expenses.
3. Profit before interest and tax has also increased by 115.38% during these two years. This indicates the improvement in the operating efficiency of the company.
Q.4 State the importance of Financial Analysis?
ANSWER: Financial Analysis has great importance to various accounting users on various matters. Income Statements, Balance Sheets and other financial data provides information about expenses and sources of income, profit or loss and also helps in assessing the financial position of a business. These financial data are not useful until they are analysed. There are various tools and methods such as Ratio Analysis, Cash Flow Statements that make the financial data to cater varying needs of various accounting users.
The following are the reasons that advocate in favour of Financial Analysis:
1. It helps in evaluating the profit earning capacity and financial feasibility of a business.
2. It helps in assessing the long-term solvency of the business.
3. It helps in evaluating the relative financial status of a firm in comparison to other competitive firms.
4. It assists management in decision making process, drafting various plans and also in establishing an effective controlling system.
Q.5 What are Comparative Financial Statements?
ANSWER: Those financial statements that enable intra-firm and inter-firm comparisons of financial statements over a period of time are called Comparative Financial Statements. In other words, these statements help the accounting users to evaluate and assess the financial progress in the relative terms. These statements express the absolute figures, absolute change and the percentage change in the financial items over a period of time. Comparative Financial Statements present the financial data in such a manner that is easily understandable and can be analysed without any ambiguity. If the accounting policies and practices for the treatment of the items are same over the period of study, only then the Comparative Financial Statements enable meaningful comparisons.
The following are the two Comparative Financial Statements that are commonly prepared:
1. Comparative Balance Sheet
2. Comparative Income Statements
Q.6 What do you mean by Common Size Statements?
ANSWER: These statements depict the relationship between various items of financial statements and some common items (like Net Sales and the Total of Balance Sheet) in percentage terms. In other words, various items of Trading and Profit and Loss Account such as Cost of Goods Sold, Non-Operating Incomes and Expenses are expressed in terms of percentage of Net Sales. On the other hand, different items of Balance Sheet such as Fixed Assets, Current Assets, Share Capital etc. are expressed in terms of percentage of Total of Balance Sheet. These percentage figures are easily comparable with that of the previous years’ (i.e. inter-firm comparison) and with that of the figures of other firms in the same industry (i.e. inter-firm comparison) as well.
The analyses based on these statements are commonly known as Vertical Analysis.
The following are commonly prepared Common Size Statements.
1. Common Size Balance Sheet
2. Common Size Income Statements
LONG ANSWER TYPE QUESTIONS
Q.1 Describe the different techniques of financial analysis and explain the limitations of financial analysis.
ANSWER: The most commonly used techniques of financial analysis are as follows
(i) 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. The financial data will be comparative only when same accounting principles are used in preparing these statements. Comparative figures indicate the trend and direction of financial position and operating results. This analysis is also known as ‘horizontal analysis’.
(ii) Common Size Statements: These are the statements which indicate the relationship of different items of a financial statement with some common item by expressing each item as a percentage of the common item. The percentage thus calculated can be easily compared with the results corresponding percentages of the previous year or of some other firms, as the numbers are brought to common base. Such statements also allow an analyst to compare the operating and financing characteristics of two companies of different sizes in the same industry. This analysis is also known as ‘Vertical analysis’.
(iii) Trend Analysis :It is a technique of studying the operational results and financial position over a series of years. Using the previous years’ data of a business enterprise, trend analysis can be done to observe the percentage changes over time in the selected data. Trend analysis is important because, with its long run view, it may point to basic changes in the nature of the business. By looking at a trend in a particular ratio, one may find whether the ratio is falling, rising or remaining relatively constant. From this observation, a problem is detected or the sign of good management is found. .
(iv) Ratio Analysis :It describes the significant relationship which exists between various items of a balance sheet and a profit and loss account of a firm. As a technique of financial analysis, accounting ratios measure the comparative significance of the individual items of the income and position statements.
(v) Cash Flow Analysis :It refers to the analysis of actual movement of cash into and out of an organisation. The flow of cash into the business is called as cash inflow or positive cash flow and the flow of cash out of the firm is called as cash outflow or a negative cash flow. The difference between the inflow and outflow of cash is the net cash flow.
Limitations of Financial Analysis
The following are the limitations of Financial Analysis
(i) Ignorance of Price Level Changes :Financial statement is based on historical cost method and fails to capture the change in price level. The figures of different years are taken on nominal values and not in real terms (i.e., not taking price change into considerations).
(ii) Misleading and Wrong information: The financial analysis fails to reveal the change in the accounting procedures and practices. Consequently, they may provide wrong and misleading information.
(iii) Fail to Provide Final Picture: The financial analysis presents only the interim report and thereby provides incomplete information. They fail to provide the final and holistic picture.
(iv) Consider Only Monetary Aspect: This is one of the limitations of financial analysis that it reveals only the monetary aspects. Only those items are considered here which can be measured in term of money and fail to disclose managerial efficiency, growth prospects, and other non-operational efficiency of a business.
(v) Non-Reliable Conclusions :Conclusion base on financial analysis may be non reliable because financial statement are based on certain concepts and conventions.
(vi) Involves Personal Biasness: The financial analysis reflects the personal biasness and personal value judgments of the accountants and clerks involved. There are different techniques used by different personnel for charging depreciation (original cost or written-down value method) and also for inventory valuation. The use of different techniques by different people reduces the effectiveness of the financial analysis.
(vii) Unsuitable for Comparisons :Due to the involvement of personal value judgment, personal biasness and use of different techniques by different accountant, various types of comparisons such as inter-firm and intra-firm comparisons may not be possible and reliable.
Q.2 Explain the usefulness of trend percentages in interpretation of financial performance of a company.
ANSWER: The Trend Analysis presents each financial item in percentage terms for each year. These Trend Analysis not only help the accounting users to assess the financial performance of the business but also assist them to form an opinion about various tendencies and predict the future trend of the business.
Usefulness and Importance of Trend Analysis:
The following are the various importance of Trend Analysis
(i) Assists in Forecasting: The trends provided by Trend Analysis help the accounting users to forecast the future trend of the business.
(ii) Percentage Terms: The trends are expressed in percentage terms. Analysing the percentage figures is easy and also less time consuming.
(iii) User Friendly: As the trends are expressed in percentage figures, so it is the most popular financial analysis to analyse the financial performance and operational efficiency of the company. In other words, one needs not to have an in-depth and sophisticated knowledge of accounting in order to analyse these percentage trends.
(iv) Presents a Broader Picture :The trend analysis presents a broader picture about the financial performance, viability and operational efficiency of a business. Generally, companies prefer to present their financial data for a period of 5 or 10 years in forms of percentage trends.
Q.3 What is the importance of comparative statements? Illustrate your answer with particular reference to comparative income statement.
ANSWER: The following are the importance of Comparative Statements.
(i) Make Presentation Simpler : Comparative statements presents the financial data in a simpler form. On the other hand, an year-wise data of the same items are presented side-by-side, which not only makes the presentation clear but also enables easy comparisons (both intra-firm and inter-firm) conclusive.
(ii) Help in Drawing Conclusion: The presentation of comparative statement is so effective that it helps the analyst to draw conclusion quickly and easily and that too without any ambiguity.
(iii) Help in Forecasting :The management may analyse the trend and forecast and draft various future plans and policy measures, with the help of comparative statement:
(iv) Help in Detection of Problems :The comparative analysis not only enables the management in locating the problems but also helps them to put various budgetary controls and corrective measures to check whether the current performance is aligned with that of the ” planned targets. With the help of the comparison of the financial data of two or more years, the financial management can easily detect the problems.
Q.4 What do you understand by analysis and interpretation of financial statements? Discuss their importance.
ANSWER: Financial Analysis has great importance to various accounting users on various matters. Income Statements, Balance Sheets and other financial data‘provide information about expenses and sources of income, profit or loss and also helps in assessing the financial position of a business.
These financial data are not useful until they are analysed. There are various tools and methods such as Ratio Analysis, Cash Flow Statements that make the financial data to cater varying needs of various accounting users.
The following are the reasons that advocate in favour of Financial Analysis
(i) It helps in evaluating the profit earning capacity and financial feasibility of a business.
(ii) It helps in assessing the long-term solvency of the business.
(iii) It helps in evaluating the relative financial status of a firm in comparison to other competitive firms.
(iv) It assists management in decision making process, drafting various plans and also in establishing an effective controlling system.
Q.5 Explain how common size statements are prepared giving an example.
ANSWER: Common size statements can be classified into two broad categories
(i) Common Size Income Statements
(ii) Common Size Balance Sheet
Common Size Statement is prepared in a columnar form for analysis. In a Common Size Statement, each item of the financial statements is compared to a common item. The analyses based on these statements are commonly known as Vertical Analysis.
The following are the columns prepared in a Common Size Statement
(a) Particulars Column:This column shows the various financial items under their respective heads.
(b) Amount Columns :These columns depict the amount of each item, sub-totals and the gross total of a particular year.
(c) Percentage or Ratio Columns :These columns show the proportion of each item to the common item either in terms of percentage or ratio.
The Common Size Statements can be presented in the following two ways.
Method 1 Percentage column is shown beside the amount column of the year to which percentage column belongs.
Method 2 Amount columns are shown first and their percentage columns are shown after the amount columns.
Example :From the following information provided by Alfa Limited Prepare the Common Size Statements.
Discover more from EduGrown School
Subscribe to get the latest posts sent to your email.