Class 12 Accountancy Notes
Unit – 8: Analysis of Financial Statements
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?
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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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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.
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 percentages 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