Class 12 Accountancy Notes
Unit – 8: Analysis of Financial Statements
Important Notes for March 2025 Exam [AHSEC Class 12 Accountancy Notes]
Q.1. What
is financial analysis? What are its significance and Limitations (5 Points)? 2012, 2013, 2016, 2023, 2024
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: 2024
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 limitation. 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
objectives, merits and limitations. 2023, 2024
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, 2022
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’.
Objectives of preparing comparative
balance sheets and income statements:
1. Evaluate financial performance over
time: These statements allow stakeholders to
compare the financial position and performance of a company across different
periods, facilitating the assessment of trends, growth, and stability.
2. Assess changes in assets,
liabilities, revenues, and expenses: By analyzing
the changes in key financial metrics over time, stakeholders can identify
shifts in the company's resources, debt levels, revenue streams, and cost
structures.
3. Identify trends, growth areas, and
risks: Comparative statements help in identifying
trends such as increasing revenues, declining profitability, or rising debt
levels. They also highlight areas of growth and potential risks that may
require attention or strategic adjustments.
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 are 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.
Objectives of preparing common size
statements:
1. Analyze relative financial
proportions: Common size statements express financial data
as percentages of a base value, making it easier to compare the relative
proportions of different components across multiple periods or companies.
2. Detect shifts in asset, liability,
revenue, and expense compositions: By expressing each line item as a
percentage of a common base, common size statements help in identifying changes
in the composition of assets, liabilities, revenues, and expenses over time.
3. Understand financial statement
structure and trends more clearly: These statements provide a clear and
standardized view of the structure and composition of financial statements,
helping stakeholders to better understand the underlying trends and dynamics
driving the company's financial performance.
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 are frequent changes in
accounting policies, then the common size statements become 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 these 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.
Objectives of trend analysis:
1. Identify long-term financial
patterns: Trend analysis involves examining financial
data over multiple periods to identify long-term patterns, tendencies, and
changes in performance indicators, providing insights into the company's
historical performance trajectory.
2. Forecast future performance based
on historical data: By analyzing historical trends,
stakeholders can make informed predictions about future performance, allowing
for better decision-making and strategic planning.
3. Pinpoint areas for improvement or
concern through historical trends analysis: Trend
analysis helps in identifying areas of strength and weakness within the
company's financial performance, enabling stakeholders to focus on areas that
require improvement or further investigation.
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 are frequent changes in accounting policies.
(iii) Since
trend percentage are based on financial statements, therefore qualitative
elements of the business are ignored.
ALSO READ: ACCOUNTANCY CHAPTERWISE COMPLETE NOTES
1. BASICS OF PARTNERSHIP (INCLUDING GOODWILL)
2. RECONSTITUTION OF PARTNERSHIP (ADMISSION, RETIREMENT AND DEATH)
3. DISSOLUTION OF PARTNERSHIP FIRM
4. ACCOUNTING FOR SHARE CAPITAL
5. ISSUE AND REDEMPTION OF DEBENTURES
6. FINANCIAL STATEMENTS OF A COMPANTY
7. FINANCIAL STATEMENTS ANALYSIS
8. RATIO ANALYSIS
9. CASH FLOW STATEMENTS
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.