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We know business is mainly concerned with the financial activities. In
order to ascertain the financial status of the business every enterprise
prepares certain statements, known as financial statements. Financial
statements are mainly prepared for decision making purpose. But the
information as is provided in the financial statements is not adequately
helpful in drawing a meaningful conclusion. Thus, an effective analysis
and interpretation of financial statements is required. Analysis means
establishing a meaningful relationship between various items of the two
financial statements with each other in such a way that a conclusion is
drawn. By financial statements we mean two statements:

(i) Profit and loss Account or Income Statement

(ii) Balance Sheet or Position Statement

These are prepared at the end of a given period of time. They are the
indicators of profitability and financial soundness of the business concern.
The term financial analysis is also known as analysis and interpretation of
financial statements. It refers to the establishing meaningful relationship
between various items of the two financial statements i.e. Income
statement and position statement. It determines financial strength and
weaknesses of the firm. Analysis of financial statements is an attempt to
assess the efficiency and performance of an enterprise. Thus, the analysis
and interpretation of financial statements is very essential to measure the
efficiency, profitability, financial soundness and future prospects of the
business units.

Types of financial statement are:

1) Comparative statement
2) Common size statement
3) Trend analysis

Financial analysis serves the following

1. Measuring the profitability

The main objective of a business is to earn a satisfactory return on the

funds invested in it. Financial analysis helps in ascertaining whether
adequate profits are being earned on the capital invested in the business
or not. It also helps in knowing the capacity to pay the interest and

2. Indicating the trend of Achievements

Financial statements of the previous years can be compared and the trend
regarding various expenses, purchases, sales, gross profits and net profit
etc. can be ascertained. Value of assets and liabilities can be compared
and the future prospects of the business can be envisaged. Assessing the
growth potential of the business. The trend and other analysis of the
business provides sufficient information indicating the growth potential of
the business.

3. Comparative position in relation to other firms

The purpose of financial statements analysis is to help the management

to make a comparative study of the profitability of various firms engaged
in similar businesses. Such comparison also helps the management to
study the position of their firm in respect of sales, expenses, profitability
and utilising capital, etc.

4. Assess overall financial strength

The purpose of financial analysis is to assess the financial strength of the

business. Analysis also helps in taking decisions, whether funds required
for the purchase of new machines and equipments are provided from
internal sources of the business or not if yes, how much? And also to
assess how much funds have been received from external sources.

5. Assess solvency of the firm

The different tools of an analysis tell us whether the firm has sufficient
funds to meet its short term and long term liabilities or not.

Analysis of financial statements has become very significant due to
widespread interest of various parties in the financial results of a business
unit. The various parties interested in the analysis of financial statements

(i) Investors :

Shareholders or proprietors of the business are interested in the well

being of the business. They like to know the earning capacity of the
business and its prospects of future growth.

(ii)Management :

The management is interested in the financial position and performance

of the enterprise as a whole and of its various divisions. It helps them in
preparing budgets and assessing the performance of various
departmental heads.

(iii)Trade unions :

They are interested in financial statements for negotiating the wages or

salaries or bonus agreement with the management.

(iv) Lenders :

Lenders to the business like debenture holders, suppliers of loans and

lease are interested to know short term as well as long term solvency
position of the entity.

(v)Suppliers and trade creditors :

The suppliers and other creditors are interested to know about the
solvency of the business i.e. the ability of the company to meet the debts
as and when they fall due.

(vi)Tax authorities :

Tax authorities are interested in financial statements for determining the

tax liability.

(vii) Researchers:

They are interested in financial statements in undertaking research work

in business affairs and practices.

(viii)Employees :

They are interested to know the growth of profit. As a result of which they
can demand better remuneration and congenial working environment.

(ix)Government and their agencies :

Government and their agencies need financial information to regulate the

activities of the enterprises/ industries and determine taxation policy.
They suggest measures to formulate policies and regulations.

(x)Stock exchange :

The stock exchange members take interest in financial statements for the
purpose of analysis because they provide useful financial information
about companies. Thus, we find that different parties have interest in
financial statements for different reasons.
Comparative statements are financial statements that cover a different
time frame, but are formatted in a manner that makes comparing line
items from one period to those of a different period an easy process. This
quality means that the comparative statement is a financial statement
that lends itself well to the process of comparative analysis. Many
companies make use of standardized formats in accounting functions that
make the generation of a comparative statement quick and easy.


The benefits of a comparative statement are varied for a corporation.
Because of the uniform format of the statement, it is a simple process to
compare the gross sales of a given product or all products of the company
with the gross sales generated in a previous month, quarter, or year.
Comparing generated revenue from one period to a different period can
add another dimension to analyzing the effectiveness of the sales effort,
as the process makes it possible to identify trends such as a drop in
revenue in spite of an increase in units sold.

Along with being an excellent way to broaden the understanding of the

success of the sales effort, a comparative statement can also help address
changes in production costs. By comparing line items that catalogue the
expense for raw materials in one quarter with another quarter where the
number of units produced is similar can make it possible to spot trends in
expense increases, and thus help isolate the origin of those increases.
This type of data can prove helpful to allowing the company to find raw
materials from another source before the increased price for materials
cuts into the overall profitability of the company.
A comparative statement can be helpful for just about any organization
that has to deal with finances in some manner. Even non-profit
organizations can use the comparative statement method to ascertain
trends in annual fund raising efforts. By making use of the comparative
statement for the most recent effort and comparing the figures with those
of the previous year’s event, it is possible to determine where expenses
increased or decreased, and provide some insight in how to plan the
following year’s event.
1) A comparative statement adds meaning to the financial data.

2) It is used to effectively measure the conduct of the business


3) Comparative statement analysis is used for intra firm analysis and

inters firm analysis.

4) A comparative statement analysis indicates change in amount as

well as change in percentage.

5) A positive change in amount and percentage indicates an increase

and a negative change in amount and percentage indicates a

6) If the value in the first year is zero then change in percentage

cannot be indicated. This is the limitation of comparative statement
analysis. While interpreting the results qualitative inferences need
to be drawn.

7) It is a popular tool useful for analysis by the financial analysts.

8) A comparative statement analysis cannot be used to compare more

than two years financial data.
Common size ratios are used to compare financial statements of different-
size companies or of the same company over different periods. By
expressing the items in proportion to some size-related measure,
standardized financial statements can be created, revealing trends and
providing insight into how the different companies compare.
The common size ratio for each line on the financial statement is
calculated as follows:

Item of
Common Size
Ratio =

For example, if the item of interest is inventory and it is referenced to

total assets (as it normally would be), the common size ratio would be:


Common Size Ratio for

Inventory =

The ratios often are expressed as percentages of the reference amount.

Common size statements usually are prepared for the income statement
and balance sheet, expressing information as follows:
• Income statement items - expressed as a percentage of total
• Balance sheet items - expressed as a percentage of total assets
The following example income statement shows both the rupee amounts
and the common size ratios:

Common Size Income Statement

Income Common-Size Income
Statement Statement

Revenue 70,134 100%

Cost of Goods
44,221 63.1%

Gross Profit 25,913

SG&A Expense 13,531 19.3%

Operating Income 12,382 17.7%

Interest Expense 2,862 4.1%

Provision for Taxes 3,766 5.4%

Net Income 5,754 8.2%

For the balance sheet, the common size percentages are referenced to
the total assets. The following sample balance sheet shows both the dollar
amounts and the common size ratios:

Common Size Balance Sheet

Balance Size
Sheet Balance


Cash & Marketable

6,029 15.1%

Accounts Receivable 14,378 36.0%

Inventory 17,136 42.9%

Total Current Assets 37,543 93.9%

Property, Plant, &

2,442 6.1%

Total Assets 39,985 100%


Current Liabilities 14,251 35.6%

Long-Term Debt 12,624 31.6%

Total Liabilities 26,875 67.2%

Shareholders' Equity 13,110 32.8%

Total Liabilities & Equity 39,985 100%

The above common size statements are prepared in a vertical analysis,

referencing each line on the financial statement to a total value on the
statement in a given period.
The ratios in common size statements tend to have less variation than the
absolute values themselves, and trends in the ratios can reveal important
changes in the business. Historical comparisons can be made in a time-
series analysis to identify such trends.
Common size statements also can be used to compare the firm to other
Comparisons Between Companies (Cross-Sectional Analysis)
Common size financial statements can be used to compare multiple
companies at the same point in time. A common-size analysis is especially
useful when comparing companies of different sizes. It often is insightful
to compare a firm to the best performing firm in its industry
(benchmarking). A firm also can be compared to its industry as a whole.
To compare to the industry, the ratios are calculated for each firm in the
industry and an average for the industry is calculated. Comparative
statements then may be constructed with the company of interest in one
column and the industry averages in another. The result is a quick
overview of where the firm stands in the industry with respect to key
items on the financial statements


1. A common size statement analysis indicates the relation of each

component to the whole.
2. In case of a Common Size Income statement analysis Net Sales is
taken as 100% and in case of Common Size Balance Sheet analysis
total funds available/total capital employed is considered as 100%.
3. It is used for vertical financial analysis and comparison of two
business enterprises or two years financial data.
4. Absolute figures from the financial statement are difficult to
compare but when converted and expressed as percentage of net
sales in case of income statement and in case of Balance Sheet as
percentage of total net assets or total funds employed it becomes
more meaningful to relate.
5. A common size analysis is a type of ratio analysis where in case of
income statement sales is the denominator (base) and in case of
Balance Sheet funds employed or total net assets is the
denominator (base) and all items are expressed as a relation to it.
6. In case of common size statement analysis the absolute figures are
converted to proportions for the purpose of inter-firm as well as
intra-firm analysis.

As with financial statements in general, the interpretation of common size
statements is subject to many of the limitations in the accounting data
used to construct them. For example:
1. Different accounting policies may be used by different firms or
within the same firm at different points in time. Adjustments should
be made for such differences.
2. Different firms may use different accounting calendars, so the
accounting periods may not be directly comparable.


Trend analysis calculates the percentage change for one account over a
period of time of two years or more.

Percentage change
To calculate the percentage change between two periods:

Calculate the amount of the increase/ (decrease) for the period by

subtracting the earlier year from the later year. If the difference is
negative, the change is a decrease and if the difference is positive, it is an

Divide the change by the earlier year's balance. The result is the
percentage change.
Calculation of Percentage Change :

(amount in 000 rupees)

(N/M: not meaningful)

2001 2000 Increase/ Percent

(Decrease) Change

Cash 6,950 6,330 620 9.8%

Accounts 18,56 19,33 (763) (3.9%)

Receivable, net 7 0

Sales 129,0 103,0 26,000 25.2%

00 00

Rent Expense 10,00 0 10,000 N/M


Net Income (Loss) 8,130 (1,400 9,530 N/M


Calculation notes:

1. 2000 is the earlier year so the amount in the 20X0 column is

subtracted from the amount in the 2001 column.
2. The percent change is the increase or decrease divided by the
earlier amount (2000 in this example) times 100. Written as a
formula, the percent change is:

3. If the earliest year is zero or negative, the percent calculated will

not be meaningful. N/M is used in the above table for not
4. Most percents are rounded to one decimal place unless more are
5. A small absolute rupee item may have a large percentage change
and be considered misleading.

Trend percentages
To calculate the change over a longer period of time—for example, to
develop a sales trend—follow the steps below:

1. Select the base year.

2. For each line item, divide the amount in each non base year by the
amount in the base year and multiply by 100.
3. In the following example, 2007 is the base year, so its percentages
(see bottom half of the following table) are all 100.0. The
percentages in the other years were calculated by dividing each
amount in a particular year by the corresponding amount in the
base year and multiply by 100.

Calculation of Trend Percentages

(amount in rupees)

2001 2000 2009 2008 2007

Historical Data

Inventory 12,30 12,20 12,10 11,97 11,74

9 2 2 3 3

Property & 74,42 78,93 64,20 65,23 68,45

equipment 2 8 3 9 0

Current liabilities 27,94 30,34 27,67 28,25 26,73

5 7 0 9 7

Sales 129,0 97,00 95,00 87,00 81,00

00 0 0 0 0

Cost of goods sold 70,95 59,74 48,10 47,20 45,50

0 0 0 0 0

Operating 42,60 38,05 32,99 29,69 27,05

expenses 0 5 0 0 0

Net income (loss) 8,130 (1,40 7,869 5,093 3,812

2001 2000 2009 2008 2007


Inventory 104.8 103.9 103.1 102.0 100.0

Property & 108.7 115.3 93.8 95.3 100.0


Current liabilities 104.5 113.5 103.5 105.7 100.0

Sales 159.3 119.8 117.3 107.4 100.0

Cost of goods sold 155.9 131.3 105.7 103.7 100.0

Operating 157.5 140.7 122.0 109.8 100.0


Net income (loss) 213.3 (36.7) 206.4 133.6 100.0

Calculation notes:

1. The base year trend percentage is always 100.0%. A trend

percentage of less than 100.0% means the balance has decreased
below the base year level in that particular year. A trend percentage
greater than 100.0% means the balance in that year has increased
over the base year. A negative trend percentage represents a
negative number.
2. If the base year is zero or negative, the trend percentage calculated
will not be meaningful.
3. In this example, the sales have increased 59.3% over the five-year
period while the cost of goods sold has increased only 55.9% and
the operating expenses have increased only 57.5%. The trends look
different if evaluated after four years. At the end of 2000, the sales
had increased almost 20%, but the cost of goods sold had increased
31%, and the operating expenses had increased almost 41%. These
2000 trend percentages reflect an unfavourable impact on net
income because costs increased at a faster rate than sales. The
trend percentages for net income appear to be higher because the
base year amount is much smaller than the other balances.

1) In case of a trend analysis all the given years are arranged in an

ascending order.
2) The first year is termed as the “Base year” and all figures of the
base year are taken as 100%.
3) Item in the subsequent years are compared with that of the base
4) If the percentages in the following years is above 100% it indicates
an increase over the base year and if the percentages are below
100% it indicates a decrease over the base year.
5) A trend analysis gives a better picture of the overall performance of
the business.
6) A trend analysis helps in analysing the financial performance over a
period of time.
7) A trend analysis indicates in which direction a business is moving
i.e. upward or downwards.
8) A trend analysis facilitates effective comparative study of the
financial performance over a period of time.
9) For trend analysis at least three years financial data is essential.
Broader the base the more reliable is the data and analysis.