Thursday, December 25, 2014

AHSEC - 12: Financial Statement Analysis Important Questions and Answers for Feb' 2017 Exam

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:
Financial Statement Analysis: It is the process of identifying the financial strength and weakness of a firm from the available accounting 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:
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 health of the company. It is done by properly establishing the relationship between the 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 Comparison: Inter-firm comparison becomes easy with the help of financial analysis. It helps in assessing own performance as well as that of others.
e)      Understandable:  Financial analysis helps the users of the financial statement to understand the complicated matter in simplified manner.
Limitations of financial analysis:
Financial analysis suffers from various limitations which are given below:
a)      Historical Analysis: Financial analysis analysed what has happened till date but it does not reflect the future.
b)      Ignores Price Level Changes: A change in the price level makes the 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.
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.

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.
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.
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.
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
b)      Common size statements,                                   2015
c)       Trend analysis,                                                          2014
d)      Ratio analysis,
e)      Cash flow analysis.
a) Comparative Financial Statements: Comparative Financial Statements is primarily an analytical study of the different items shown in the Income Statement and Balance Sheet over a period of time. It may refer to:
(i) Financial statements of an enterprise for two or more accounting years (Inter-period Comparison)
(ii) Financial statements of different enterprises for the same accounting year (Inter-firm Comparison).
The Financial Statements reveals the trading results and financial statement of a concern. But the Comparative Statement presents a review of two or more years. It shows the absolute change from one period to another.
Comparative statements are of two types – “Comparative balance sheets and Comparative income statements”.
Merits of Comparative Financial Statements:
(i)     Comparison of financial statements helps to identify the size and direction of changes in financial position of an enterprise.
(ii)   These statements help to ascertain the weakness and soundness about liquidity, profitability and solvency of an enterprise.
(iii) These statements help the management in making forecasts for the future.
Demerits of Comparative Financial Statements:
(i)     Inter-firm comparison may be misleading if the firms are not of the same age and size, follow different accounting policies.
(ii)   Inter-period comparison will also be misleading if there is frequent changes in accounting policies.
b) Common Size Statements: Common size statement is the statement in which amounts of individual item of balance sheet and profit and loss account for two or more years are written. These amounts are further converted into percentage to some common base. It 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)      Comparison of the performance and financial condition in respect of different units of the same industry can also be done.
(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)      Inter-firm comparison may be misleading if the firms are not of the same age and size, follow different accounting policies.
(iii)    Inter-period comparison will also be misleading if there is frequent changes in accounting policies.
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 for several years. Under this method trend percentages are calculated for each item of the financial statements taking the figure of base year as 100. 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. 

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