Analysis & interpretation of fs

Notes by Prof. M. B. Thakoor (1)

ANALYSIS & INTERPRETATION OF FINANCIAL STATEMENTS

Q.1. Explain Comparative Statements? Explain its Merits & Demerits?

Ans: A Comparative Financial Statements is a statement of Financial Position of a business
designed in such a way where a comparative study is undertaken of different accounting
items, to measure the performance of a Business Activity.

There are 3 types of Comparison
1) Inter Firm Comparison
2) Intra Firm Comparison
3) Inter Period Comparison

1) Inter Firm Comparison:-
It means comparing the financial statements of 2 different organization for the same
accounting period in order to find out the related strength and weakness of the Business
Activity.
2) Intra Firm Comparison:-
It means comparing the same financial figure of 2 product or more products of same
company ex. HLL compares sales of Lux, Rexona, Liril for Jan. 2003.
3) Inter Period Comparison:-
It means comparison of Financial Statements of the same Business Organization for 2
different periods in order to find out whether the business is progressing or declining.

Merits:
1) Indicate the Direction of Financial Position:
These statements are very useful to the Financial Analyst because they indicate the
direction of the movement of the financial position and performance over the year.

2) Reveal Nature & Trend:
Comparative Statement bring out more clearly the nature and trend of current changes
affecting the enterprise by presenting a review of past activities.

3) Identifying Trouble Spots:
Due to IFC & Intra Firm Comparison Comparative Statement help to identify trouble
spot.

Disadvantages:
1) Misleading picture, if consistency in accounting principle not followed.
2) Constant change in price level tender accounting statement useless for comparison.
3) Inter firm comparison is useless, unless all the firms are of the same age, size and
follow the same principles.
4) If there exists any Abnormal Period between 2 successive accounting period then it
will prove to be a pointless analysis.



Q.2. Explain Common Size Statements? Explain its Merits & Demerits?

Ans: It is a Statement in Vertical Form in which every item of the Financial Statement is
reduced to a common base. This was introduced with a view to overcome the limitation
of Comparative Statement.

There are 2 types of common size statements.
(1) Common Size Balance Sheet:
It is also known as 100% Balance Sheet. Here we take total assets and Liabilities &
Capital as a common base and the total of the assets and also the liabilities and
capital as 100%.

Thus a statement is prepared to bring about the ratio of each asset or liability to the
total of the balance sheet is known as common size statement.

In analyzing the balance sheet, a statement is prepared to work out the ratio of each
assets to total assets and each liability and capital to total liabilities & capital.

(2) Common Size Income Statement:
“A statement prepared to bring out ratio of each item of expense or revenue to Net
Sales, taking Net Sales as 100 is known as common size income statement”

This is also known as “Vertical Analysis” or “Static Analysis” because we observe
relationships between amounts within a single financial statement”

Advantages of Common Size Statement:
(1) It reveals Sources and Application of Funds in a nutshell which help in
taking decision.
(2) If common size statements of 2 or more years are compared it indicate the
changing proportion of various components of Assets, Liabilities, Cost, Net
Sale & Profit.
(3) When Inter Firm Comparison is made with the help of Common size
statement it helps in doing corporate evaluation and Ranking.

Disadvantages of Common Size Statement:
(1) No Established Standard Proportion:
Common Size Statements are regarded as useless as there is no established
standard proportion of an asset to the total asset or an item of expense to the
net sales.
(2) Consistency Required:-
If Financial Statement of a Particular business organization are not prepared
year after year on a consistent basis comparative study of common size
statement will be misleading.



Q.3. Explain Trend Analysis? Explain its Merits and Demerits?

Ans: Trend Analysis is a statement in vertical form where the earliest year is taken as base
year and the value of all the items in the financial statements will be related to the base
year in terms of % where value of each item in base year will be considered as 100.
Trend % analysis move in one directions either upward or downward progression or
regression.

Advantages:
(1) Trend % indicate the increase or decrease with the magnitude of change in %
which is more effective than absolute data.
Ex. If we say profit increases by Rs. 50,000/- it will be meaningless unless we find
by what % the profit has increased.
(2) Facilitate efficient comparative study of financial performance.
Limitations:
(1) It will give a misleading picture if consistency in accounting principle is not
followed.
(2) Constant change in price level render accounting statement useless for comparison.
(3) During inflationary period the data over a period of time become incomparable,
unless the absolute rupee data is adjusted.
(4) There is always the danger of selecting the base year which may not be
representative, normal & typical.
(5) Trend % should be studied in relation with Absolute figure otherwise it
give misleading picture. For ex. No. of student where 2, the next year they
increased to 4. Now trend % show 100% increase but absolutely we get clear
picture than trend %.

Q.4. What are the objectives of Financial Analysis?
(A) Financial Statement Analysis is done keeping in mind the following objective.
(1) Profitability Analysis.
(2) Liquidity Analysis.
(3) Solvency Analysis.

(1) Profitability Analysis:
User of Financial Statement may analyse financial statements to decide past and
present profitability of the business. Prospective investor may do profitability
Analysis before taking a decision to invest in the shares of the company.

(2) Liquidity Analysis:
Supplier of goods, Moneylender & financial Insulation may do liquidity analysis to
find out the ability of the Company to meet its obligation which are of short term
nature.

(3) Solvency Analysis:
It refers to Analysis of long term financial position of a company. This analysis
helps to test the ability of a company to repay its debts.

After making the above analysis comparison is made over a number of year,
Interpeirod Comparison, similar intra firm comparison & Intra firm Comparison is
made.



Q.5 What is the logic for giving the name Common Size Statement?
Ans. The logic for giving the name common size statement is the sale in case of Revenue
Statement & total Assets & total Liabilities in case of Balance Sheet are take at a
common BASE i.e.100 & this is the logic for giving its name common size statement
which will be comparable in nature and which will be identifiable in size.

Q.6 Distinguish between Dynamic & Static Analysis:

Horizontal / Dynamic / Trend Analysis Vertical/Static Analysis
1) Period:
It requires financial statement of 2 or more It requires financial statement of 1 year.
year
2) Information:
It gives information in Absolute as well as in It gives information only in % form.
% form.
3) Items:
It deals with same item of different year. It deals with different item of the same year.
4) Use:
It is used for Time Series Analysis It is used for Cross Section Analysis.

Q.7. What are the Reasons behind decreasing trend in sales & expenses?
A) Reason behind decreasing trend in sales
1. Low Quality of Goods.
2. Change in Demand due to change in fashion.
3. High cost so High price of sale.
4. Low quality of Raw Material used.
5. Lack of good selling method.
6. Poor Advertising & publicity.
7. Low stock turnover ratio & goods not available to customer when required.
8. Shortage of Raw Material
9. General Economic Recession

(B) Reason behind decreasing trend in expense.
1. Better quality of Raw Material
2. Low cost of production.
3. Better use of TQM method.
4. Better logistic method.
5. Efficient use of material handling.
6. Low cost of Raw Material.
7. Cheap availability of labour.
8. Better operating efficiency i.e. Less Conversion Period.


Analysis & interpretation of fs

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