LEARNING OBJECTIVES:

(i) To prepare Financial Statements.

(ii) To analyse Financial Staements using comparative and common size analysis.

LEARNING OUTCOME:

(i) Understand Financial position of a company from Annual Report

(ii) Analyse and Interpret the Comparative , common size and trend statements given in
Annual Report.

Meaning of Annual Report: Annual report of any successful corporate entity serves the purpose
of a standardized quality mirror which reflects true and fair financial picture of the reporting
entity. In early seventies financial reporting was being done to fulfill informational quarries of
shareholders only.

Growth in the number of corporations with the passage of time has created a new type of
corporate reporting framework in which financial reporting is done in such a way that it provides
not only financial information through annual reports but also concentrates on disclosures of
additional information for other than the primary users of annual reports like, research scholars,
consumers, accounting professionals and community at large.

Additional information being provided by corporations through annual reports differ with each
other. Let us discuss what kind of additional information is expected by various users of annual
reports in addition to the contents of annual reports made mandatory by Company Law.

Section 219 and 220 of Company Law require directors of a Company to present annual accounts
for the consideration of the shareholders. A failure to present the accounts is a punishable offense.
These annual accounts are generally presented through annual reports.

Additional Information Expected:

(I) Management discussion and analysis

(a) Overview
 (b) Strategic Moves

(d) Segmental Analysis

(e) Technological Initiatives

(f) Business Restructuring

(II) Notes on financial statements – sig. accounting policies (5, contingent liability), inventories,
dep., share buyback, intangible assets, Borrowings (secured loans), Exceptional items any 2,
Contingencies and commitments (any 3), Disclosures on financial instruments, Segment
reporting.

(III)Environment report

(IV) Social report

(V) Shareholder information and Stock market

data .

(VI) Financial highlights of ten years

(VII) Accounting ratios

(VIII) Foreign currency transactions.

(IX) Accounting for price level changes.

(X) Valuation of human resources.

I. Management Discussion and Analysis:

Under this head, an additional information can be provided to the users of annual report
regarding management decisions, perception and analysis of management decisions taken over
during financial year.

Contents under this head can be discussed as under:

(a) Overview:

It has been noticed from annual reports of some reputed companies that management generally
present the focus of its unit on different areas of operations since the inception of the unit. Under
this sub-head companies are not providing information to its user groups on overall view but
some material on outlook of the current financial year. An analysis can be made on general
growth which took place during financial year for instance.

i. “Gross Revenue grew by 15% year to year to Rs 4982.3 crores in 1999-2000, operating

margins remained flat despite improved assets utilization.”

ii. Operating profits grew from Rs 678 crores in 1998-99 to Rs 756 crores in 1999-2000.”27

(b) Strategic Moves:

Strategic Moves made by management during the year under report can be discussed and
presented under this head to gain confidence of shareholders and General public. Management
has to remain alert throughout the year to deal with various problems and shareholders real
owners of corporate entity being absentee owners look upon management to take various
strategic moves throughout the year on their behalf. Disclosure of such information will enhance
their confidence in management.

For instance various strategic moves taken over by management of Grasim Industries Ltd.

were as under to enhance shareholder value:

(i)Cement restructuring
(i) Commenced trial runs at “Grasim South”

(ii) Restructured existing high cost debt

(iii) Suspended operations at Mavoor

(iv)Rationalisation of work force at the Fibre Division

(c) Segmental Analysis:

Many companies engaged in several lines of business, and report their results separately.
Separate information about each line of business is considered to be very helpful in making
predictions about the future of the company as a whole. However, much caution is necessary in
preparing segment reports. IAS 14 requires large, publicly held companies to provide segment
information.

While a company may maintain separate revenue and expense accounts for each of its segments,
it will still have to contend with indirect and joint costs. Examples of such costs are: rent and
expenses relating to a building used by two or more segments; cost of running the departments
used by several or all segments, such as personnel, accounting, purchasing, etc.,; advertising
expenses, expenses of the head office; and so forth.

There are two alternative ways to show such costs in segment reports:

1. No attempt is made to show indirect costs separately for each segment, but they are
shown only in the total column. Under this method, the difference between the
revenues and direct costs of a segment should be referred to as ‘contribution’ rather
than as ‘profit’.

2. Indirect costs are allocated among the segments on a reasonable basis. According to
some theorists all such allocations are somewhat arbitrary, and information based on
them is not very reliable. However, in practice, allocation of indirect costs is quite
common. Some of the bases that are used for making allocations are listed below:
 a. Area occupied, such as for allocating rent and / or other occupancy costs of a
building

b. Actual usage, such as kilowatt hours of electricity used by each segment.

c. Number of employees, such as for allocating costs of the personnel department

d. Number of purchase orders or amount of purchases, such as for allocating

expenses of the purchasing department

e. Amount of sales – used for items that have no other rational basis

An analysis and review can be presented if reporting entity has various segments in its
organisational structure. Segmental analysis will present a better picture before users of annual
report and help them to understand the performance of each segment separately.

A comparative analysis will depict a clear and better picture for instance:
(d) Technological Initiatives:

An analysis can also be made on technological initiatives taken by management during the year
under report. In the world of rapidly changing technology, industrial units are also taking
initiatives in changing technologies. A light on changing technology will help in gaining
confidence of consumers.
For instance: Technology initiatives taken by LML Limited in 1999- 2000 are reported as under.
“The goal of the company is to become self-sufficient in technology so as to be able to introduce
vehicles relevant for the Indian market in the short to medium term and to build on this capacity
and develop vehicles for overseas market in the medium to long term. The Company sources
need based expertise and technology from overseas parties.
Apart from up-gradation of existing products and new product development, the company is
also working for the development of two wheelers based on alternate fuels (like LPG) and direct
fuel injection engines, as part of its commitment for environment. The R&D facilities at Kanpur
are recognized by the Department of Science and Technology, Government of India.
The R&D Centre employs around 172 technical personnel and provides facilities in the areas
of:

(i) CAD/CAM systems

(ii) Rapid proto typing

(iii) Computer simulation

(iv) Dynamo meters and

(v) Tool making

(e) Business Restructuring:

Management discussion and analysis may include views of management on business

restructuring Enhancing competition, open up of economy, concept of global market, entry of
multinational companies has compelled Indian Companies to have business restructuring.

Management’s discussion on this aspect will enlighten users of annual reports about policies of
business restructuring.

II. NOTES ON FINANCIAL STATEMENTS

Meaning:

Notes on financial statements are also referred to as footnotes. These provide additional
information pertaining to a company's operations and financial position and are considered to be
an integral part of the financial statements. They are necessary because not all relevant financial
information can be communicated through the amounts shown (or not shown) on the face of the
financial statements. The notes are required by the full disclosure principle.

The first note to the financial statements is usually a summary of the company's significant
accounting policies for the use of estimates, revenue recognition, inventories, property and
equipment, goodwill and other intangible assets, fair value measurement, discontinued
operations, foreign currency translation, recently issued accounting pronouncements, and others.

The first note is followed by many additional notes that contain the details (including schedules
of amounts) for items such as inventories, accrued liabilities, income taxes, employee benefit
plans, leases, business segment information, fair value measurements, derivative instruments
and hedging, stock options, commitments and contingencies, and more.

Each external financial statement should also include a reference (usually as a footer) which states
that the accompanying notes are an integral part of the financial statements.

III. Environment Report:

Corporate industrial sector in every country is serving the society by providing goods and
services but also destroying environment by creating water, air and soil pollution. Mills, mines,
chemical industries, tanneries and other concerns often have waste waters containing highly toxic
or objectionable chemicals that can render large streams unfit for future use.

Safe to manufacture implies environmental issues ISO- 14000 series has been introduced and
certification under this series is given only to industrial unit which is environmental friendly.
Reporting entity should provide environment report along with financial issues.

General public is interested to know the damages being made by an industrial unit and activities
being performed by the unit for environmental protection. A regular environmental disclosure
will improve the image of the reporting entity. Various companies are voluntarily disclosing
environmental information in a variety of ways like press- releases reports to environmental
regulators, environmental audit reports, etc.

A research study was done by Dr. K. Eresi on “Information disclosure in Annual report” which
was published in Journal “The Chartered Accountant” January 1996. Dr. Eresi has made
following conclusions. “Only 30% of the Sample Companies (68 companies) have disclosed EI
and remaining 70% did not show any concern for environment and environmentally sensitive 6
companies have disclosed only positive information about environmental matters except one
company which has showed negative information also.”
Case Discussion: Environment Protection: A Way of Life at Grasim:

An extract of annual report of Grasim Industries Ltd. is reproduced as under:

At Grasim we firmly believe in sustainable development. We fully appreciate that the earth’s
resources and its capacity to absorb pollution and regenerate are finite. Therefore, operations
at all of our Units are conducted in a manner that respects the ecological balance.

Naturally then the environmental dimension forms an integral part of all business decisions.
Pollution prevention, product stewardship and clean technologies enable us to fulfill our goal
of sustainable development.

We have clearly spelt out production norms that enable us to run our operations in an Eco-
efficient manner. These revolve round:

(i) Adoption of cleaner technologies. ,

(ii) Designing products and processes with as little environment impact as possible.

(iii) Optimizing resource efficiency in plant operations to minimize waste while maximizing
treatment of inevitable wastes in an environmentally compatible manner.

(iv) Creation and building of an Eco-friendly family.

To achieve these goals, environment protection systems and processes are well in place.

To meet the challenge of environment protection in a proactive manner, unavoidable wastes

are dealt with in the most efficient and scientific way.

State-of-the art industrial treatment plants are in operation at all of our Units for air, water and
solid wastes. An appreciable quantity of the treated effluent is reused to meet the plants’ needs.
The solid waste sludge is used as a soil conditioner in the special green belts developed at the
sites. Alongside, full-fledged laboratories for testing of treated effluent, water and air have been
set up at the plants.
Pulp and Fibre units at Harihar and Nagda are certified under ISO 14001. Our ongoing focus has
been and continues to be directed towards increasingly developing environment friendly process
and sub- processes. We have succeeded in eliminating the use of heavy metals such as zinc in the
conventional fibre process as also in the fibre, which is a path-breaking feat.

At the Pulp Plant at Harihar, Bio-methanation unit for treatment of BOD rich waste liquor
generates methane, which is used as a substitute for LDO in the pulp flash drying process.

At Pulp and Fibre units, we are continuously innovating the process and more effective treatment
of the inevitable waste and the following innovations in that direction are under progress:

At Birla Cellulosic, we have worked out a novel method of treating and reusing effluents. We
have opted for vermicastings consisting of diverse bacteria in abundance, viz. cellulose
degrading, naturally oxidising, nitrogen fixing and fungi actinomycetes, a facilitating bacteria.
These render the treated effluent highly productive for agriculture. An innovative experiment
using the approach of phyto-remediation for utilisation of secondary treated effluent is being
carried out at our treated effluent disposal farm in Birla Cellulosic. Mainly plantation crops like
coconut, accasiamangium (Australian teak) have been grown and field crop like vegetables,
cotton, sugarcane and wheat cultivated.

(i) Experiments on utilisation of fly ash and ETP sludge were carried out on wheat cultivation.
Periodic analyses of the fruits and vegetables at reputed labs have indicated encouraging results.

(ii) Successful trial of proto-type sludge dryer for ETP sludge drying to facilitate final disposal of
incineration in existing Boilers.

At Textile units-Grasim Gwalior, Bhiwani Textiles Mills and Elegant Sinners-towards waste
recovery, we recycle steam condensate through Ogdem Pump in the fibre dyeing process. The
condensate water is used in the final process and this has resulted in saving energy besides
upgrading the quality of the dyed fibre. Through recycling and utilising waste steam and water,
we have been able to improve the recovery of chemicals from the effluent discharge.

Cement units are ISO 14001 certified. Reuse of bi-products and residual wastes is in-built into
the cement production systems. Our production processes are highly energy efficient. The
environmental standards followed at our cement plants are fully in conformity with the
stringent local and national regulations. To ensure a dust free atmosphere in and around the
plant and not to allow dust to escape into the environment, our cement plants have electrostatic
precipitators and dust collectors such as bag house and bag filters.

As in all the Plants, at Sponge Iron Unit at Salav, at Alibaug, environment management systems
are accorded a priority. The superior technology Plant has in-built pollution abatement systems.
Its liquid effluent is recycled. As it uses natural gas as the prime source of energy, gases from its
stocks are free of pollutants. Alongside dry bag filters and wet scrubbers ensure a dust free
environment.

A systematic assessment at all of the plants for potential hazards and the risk of accidental
pollution is in-built as a proactive measure.

Through these ways of conserving the environment, we make sure that in meeting our needs,
we do not encroach upon the ability of future generations to meet their needs of the earth’s finite
resources.

In fact our Plants have a very wooded look, given the thousands of trees that encircle them.

Importantly it adds grace and beauty to our Plants. The effect is one of tranquility.
 Case Discussion: TATA Steel Annual Report 2018

Environment

GHG emissions Waste gas utilisation

• Reduction in fossil fuel based power consumption
• Carbon rate reduction in blast furnace
(Refer Page 55)

Water • Minimise effluent discharge

Consumption • Augment intake through recycling/ harvesting
(Refer Page 56)

Resource • Enhance value from circular economy system- LD

efficiency slag, By-product gas & Scrap
• Global benchmark in operational efficiency
(Refer Page 58)

Biodiversity Sustainable Mining through focused initiatives

around prevention, recovery, reuse and recycle
to minimize ecological footprint
(Refer Page 57)

Source: TATA Steel Annual Report 2018

 Project Undertaken in 2017-18

Area Project Description Impact Created

Environment Reduction in Specific Water 26.5% reduction in water

Consumption at Wet Processing Plant consumption
of OMQ by process optimization and
design modification in water circuit at
HBF and TSK blast furnace for recycling
and reuse.

Source: TATA Steel Annual Report 2018

III. Social Report:

Financial statements prepared under financial accounting are basically meant to serve the needs
of shareholders and investors in making sound economic decisions. Exchanges between a
corporation and its social environments are practically ignored.

This nature of financial accounting has led to, in recent years, a serious debate that business
activity should conform to socially desirable objectives i.e. products should not be harmful to the
users, environment should be saved from industrial malpractices in the form of pollutions of
every kind.

Reporting entity is supposed to disclose social information to the society. Hence a social report
along with financial reporting is also desirable as an additional information in annual reports.
Social report must convey the social transactions taken place between corporate entity and society
during the year under report.

Number of industrial units are performing social activities like, arranging medical camp,
spreading education, providing various canteen and ration facilities to employees. Some of the
units have also undertaken village adoption schemes.

IV. Shareholder Information and Stock Market Data:

Reporting entity is expected to provide full information related with shareholders. Entity should
disclose additional information for shareholders in addition to routine information. Most of the
corporations are providing shareholders information in descriptive form as well as data based
information on number of shares, categories of shareholders, dematerialisation of shares and
liquidity and outstanding GDR warrants, transfer agents, share transfer system and investor
services.

V. Financial Highlights of Last 10 years:

Additional information may include ten year highlights on various financial items that
information will help the users of financial information look upon trend formed with the help of
ten years highlights. Users will have a better view of performance of the reporting entity over a
period of time.
Items to be shown in highlights can be as under:

(1) Sales

(2) Other Incomes

(3) Gross profit

(4) Operating Expenses

(5) Interest

(6) Depreciation

(7) Net Profit

(8) Fixed Assets

(9) Investments

(10) Current Assets

(11) Shareholder’s Funds

(12) Reserves

VI. Accounting Ratios:

Accounting ratios on liquidity, solvency, profitability and activity can also be presented as
additional information in annual report. Sometimes an absolute figure conveys nothing. But if
the same item is presented in relation to some other item, it may convey better information. Ratio
analysis has been assumed very popular technique of financial analysis since its inception.
Following ratios can be calculated and presented for users of annual reports:

(1) Current Ratio: Current Assets (excluding current investments) / Current liabilities

(Current liabilities: Trade Payables + Other current liabilities + Short-term provisions –

Current maturities of Non-current borrowings and Finance Lease Obligations)

(2) Quick Ratio

(3) Return on Investment

(4) Debt Equity Ratio: Net Debt / Average Net Worth

Net Debt: Non-current borrowings + Current maturities of Non-current borrowings and

Finance Lease Obligations + Current borrowings – Current investments – Non-current
balances with banks – Cash and Bank balances

(5) Debt Service Ratio

(6) Stock Turnover

(7) Stock Velocity

(8) Debtors Turnover: Average Debtors / Turnover in days

(9) Debt Collection Period

(10) Payable Turnover

(11) Working Capital Turnover.

(12) PBET / Turnover: Profit before exceptional items and tax / Turnover

(13) Return on Average Capital Employed: EBIT / Average Capital Employed

 (Capital Employed: Total Equity + Non-current Borrowings + Current maturities
of Non-current borrowings and Finance Lease Obligations + Current Borrowings
+ Deferred tax liabilities)

(14) Return on Average Net Worth: PAT (including discontinued operations) /

Average net worth

(Net worth: Total equity + Preference Shares issued by subsidiary companies +

Warrants issued by a subsidiary company + Hybrid Perpetual Securities)

(15) Assets Turnover: Turnover / (Total Assets – Investments – Advance Against

Equity)

(16) Inventory Turnover: Average Inventory / Sale of Products in days

(17) Interest Service Coverage Ratio: EBIT / Net Finance Charges

(18) Net worth per share: Net Worth / Number of Equity Shares

(19) Earnings Per Share: Profit attributable to Ordinary Shareholders / Weighted

average number of Ordinary shares

(20) Dividend Payout Ratio: Dividend (includes tax on dividend) / Profit after tax

(21) P/E Ratio: Market Price per share / Basic Earnings per-share continuing
operations

(22) Earnings Yield Ratio

VII. Foreign Currency Transactions:

Generally reporting entities use to disclose information on foreign currency transactions in

statement of significant accounting policies. However an additional information is expected on
foreign currency transactions by the companies which are involved in foreign trade. Some of the
companies may make investments in shares of foreign subsidiary companies. Detailed
information can be presented in Annual report.

VIII. Accounting for Price Level Changes:

Financial statements being submitted under conventional accounting are prepared on the basic
assumption that financial information presented through these financial statements is based on
stable monetary unit which is violated in the periods of rising prices.

Following effects of inflation on financial statements are noted:

(i) Profits are overstated in income statement which leads to number of problems further like,
over distribution of dividend, settlement of wage claims on the terms, which reporting entity
could not afford, excess taxation on reporting income, under pricing of sales all mislead the
investors regarding performance of reporting entity.

(ii) Book values of assets in position statements become unrealistic.

(iii) Inadequate funds available for replacement of fixed assets.

(iv) Capital erosion is more

(v) Faulty valuation of inventories

Reporting entities are expected to submit at least separate disclosure on effects on inflation on
income and position statements if cannot account for with the help of accounting for price level
changes.

IX. Valuation of Human Resources:

The competence and calibre of human beings working in an organisation are the real assets of an
enterprise. An organisation with incompetent staff will fail sooner or later where as on the other
hand any enterprise having competent staff may survive and perform well even in adverse
situations.
Mitsushita Company Japan which has assumed status of world leader in electronics has attained
the top position due to calibre, commitment loyalty and character of the employees working in
the campus of Mitsushita.

It is very sad to note that accounting researchers even till today could not develop a full proof
accounting system to evaluate the human resources and to put them on balance sheet. Top
companies particularly in public sector have started providing information on their human assets
through their annual reports.

Auditor’s Opinions:

Companies Act 1956 in India has made it obligatory for the companies incorporated under Act to
appoint auditors in an annual general meeting. An auditor appointed at one annual general
meeting holds office from the conclusion of that meeting until the conclusion of next annual
general meeting as per Sec 224 of Company Law.

Every company in its annual reports submits audit report duty signed by auditors appointed at
annual general meeting. Auditors have to audit balance sheet and profit and loss account of the
company and have to provide information to the shareholders of the company in form of their
opinions.

On preparation of Profit and Loss account and Balance Sheet for example they have to give their
opinion, that whether Profit and Loss account and Balance Sheet comply with accounting
standards referred to in sub section 3C of Section 211 of Companies Act, 1956 to the extent
applicable.

Legal requirements:

Section 227 of Companies Act 1956 has mentioned various power and duties, every auditor has
the right of access to the books and accounts and vouchers of the Company. The audit report
submitted by auditor should state clearly whether the accounts are kept in accordance with the
provisions of the Act and whether they give a true and fair view of the state of affairs of the
company.
Section 227 (1 -A) of the act require the auditors to inquire into the following matters:

(1) Whether Loans and advances made by the Company on the basis of security have been
properly secured and whether the terms are not prejudicial to the interests of the Company or its
members.

(2) Whether book entry transactions are not prejudicial to the interests of the Company.

(3) Whether the Company is not an Investment or a banking Company, whether any securities
have been sold by the Company at a price less than at which they were purchased.

(4) Whether personal expenses have been charged to revenue account.

(5) Whether Loans and advances made by the Company have been shown as deposits.

(6) Whether cash has been actually received in respect of any shares shown in the books to have
been allotted for cash. If no cash has been received whether the position stated in the books is
correct.

Financial Statement Analysis

Financial statements are the summaries of the operating, financing and investment activities of
business. It must give useful information for investors and creditors in making investment, credit
and other business decisions (Pamela, 1999). Financial statement analysis in accounting arena is
effectual device for different users of financial statements, each having dissimilar objectives to
learn about the financial circumstances of the unit. Financial statements are developed to take
wise decisions for company. Financial statement analysis compares ratios and trends calculated
from data found on financial statements. Financial ratios permit experts to compare output of
business to industry averages or to specific competitors. These comparisons assist recognize
financial vigour and flaws. The term 'financial analysis' also termed as 'analysis and interpretation
of financial statements', denotes to the process of determining financial strengths and limitations
of the company by establishing strategic affiliation between the items of the balance sheet, P&L
A/c and other operative data. It is the combined name for the tools and techniques that gives
significant information to decision makers.
The main intent of financial analysis is to analyse the information contained in financial
statements in order to review the prosperity and financial reliability of the firm. A financial
analyst appraises the financial statements with various tools of analysis before reporting on the
financial strength or weakness of an enterprise. Basically, it is done to assess the financial status
and performance of entity from the information contained in financial statement.

Financial statement analysis is a noteworthy business movement because financial statements of

firms present helpful information on its financial rank and profit levels. These statements also
assist a shareholder, a regulator or a company's top management executive to recognize operating
data, assess cash receipts and payments during a period and evaluate owners' investments in the
company. A good analysis and explanation of financial statement can offer valuable insights into
a firm's performance.

It facilitates investors and creditors to evaluate past performance and financial status and predict
future performance. The principal objective of financial reporting is to give information to present
and potential investors and creditors and others to make rational investment, credit and other
decisions. Successful decision making requires assessment of the past performance of companies
and assessment of their future prospects. Major aim of a company's financial analysis for a specific
period is to consider the financial position of the company, where it views the company's financial
balance and debt performance. The obtained parameters are of great importance, since it is the
vital for growth, development and continued existence of companies, mainly because they
determine the ability of its financing. Financial analysis is also helpful to determinate the
proprietary position of the company, which aims to thoroughly analyse company's assets in terms
of manifestations, to analyse the structure of assets, the satisfactoriness of their goals and
objectives, and to find out the degree of capacity utilization, efficiency of use and speed of their
skill. Financial analysis is valuable for firms to determinate the position of the company yield,
based on the determination of earnings power, and to analyse income statement or to analyse the
structure of incomes and expenditures, including analysis of the lower point of return and
quantification of the business, financial and overall business risks.

Financial statements must be realistically presented for quality business and investment
decisions, which indicates that their reliability has to be confirmed through the system of external
control by independent third parties such as auditors. The analysis of financial statements by
their users aims to change the information presented in succinct and accessible forms for certain
decisions.
Approaches: There are two major approaches for financial statement analysis that include
traditional and modern approach. Traditional approach is based on the financial data contained
in financial statement and considers the statement composed of income statement and balance
sheet. Financial ratios are used to assess the monetary position of firm. Modern approach to
financial statement analysis emphasizes financial and non-financial factors of financial statements.
Function

Key function of financial statement analysis is that it enables firms to review operating data and
appraise intermittent business performance. A corporation also may evaluate financial
statements to estimate levels of cash flows and owner investments. On the other hand, a regulator
may review a company's retained earnings statement to evaluate corporate shareholders'
accounts.

Different parties involved in financial statement analysis: In this analysis, different users are
interested which are categorized into two parts:
Techniques and tools of financial statement Analysis

Financial statements provide thorough information about assets, liabilities, equity, reserves,
expenses and profit and loss of an enterprise. They are not readily understandable to concerned
parties such as creditors, shareholders, and investors. Therefore numerous techniques are used
to analyse and interpret the financial statements. Techniques of analysis of financial statements
are mainly categorized into three types:

1. Cross-sectional analysis: It is also termed as inter firm comparison. This analysis assists in
analysing financial attributes of an enterprise with financial characteristics of another
parallel enterprise in that accounting period.
2. Time series analysis: It is also known as intra-firm comparison. This procedure indicates
the relationship between different items of financial statement is established, comparisons
are made and results obtained. The basis of comparison may be comparison of the
financial statements of different years of the same business unit, comparison of financial
statement of a particular year of different business units.
3. Cross-sectional cum time series analysis: This analysis is aimed to compare the financial
characteristics of two or more enterprises for a definite accounting period. It is possible to
extend such a comparison over the year. This approach is most successful to appraise
financial statements.

The scrutiny and explanation of financial statements is used to verify the financial status of the
firm. Various tools or methods are used to study the relationship between financial statements.
 A. Comparative financial statements
B. Common size statements
C. Trend analysis
D. Ratio analysis
E. Funds flow analysis
F. Cash flow analysis

A. Comparative financial statements: comparative study of financial statements is the

comparison of the financial statements of the business with the preceding year's financial
statements. It facilitates detection of weak points and applying remedial measures.
Practically, two financial statements (balance sheet and income statement) are prepared
in comparative form for analysis purposes.
1. Comparative Balance Sheet: The comparative balance sheet demonstrates the
different assets and liabilities of the firm on different dates to make comparison of
balances from one date to another. The comparative balance sheet has two
columns for the data of original balance sheets. A third column is used to show
change (increase/decrease) in figures. The fourth column may be added for giving
percentages of increase or decrease. While interpreting comparative Balance sheet
the interpreter is accepted to study the following aspects:
I. Current financial position and Liquidity position
II. Long-term financial position
III. Profitability of the concern
II.For studying current financial position or liquidity position of a concern, interpreter must
investigate the working capital in both the years. Working capital is the excess of current assets
over current liabilities.
III.For studying the long-term financial position of the concern, one should examine the changes in
fixed assets, long-term liabilities and capital.
IV.Another aspect to be understood in a comparative balance sheet is the profitability of the concern.
The study of increase or decrease in profit will help the interpreter to observe whether the
profitability has improved or not.

After studying various assets and liabilities, a judgment should be formed about the
financial position of the concern.

B. Common size statements and trend analysis: The common size statements (Balance
Sheet and Income Statement) are revealed in analytical percentages. The figures of these
 statements are shown as percentages of total assets, total liabilities and total sales
correspondingly.

Common size balance sheet: A statement where balance sheet items are expressed in the
ratio of each asset to total assets and the ratio of each liability is expressed in the ratio of
total liabilities is called common size balance sheet. Thus the common size statement may
be prepared in the following way.

The total assets or liabilities are taken as 100.

The individual assets are expressed as a percentage of total assets i.e. 100 and different liabilities
are calculated in relation to total liabilities.

Trend analysis: Trend analysis appraises an organization's financial information over a

period of time. Periods may be measured in months, quarters, or years, depending on the
circumstances. The objective is to compute and analyse the amount change and percent
change from one period to the next. For calculating the percentage change between two
periods, calculate the amount of the increase (or 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 increase. Divide the change by the earlier year's
balance. The result is the percentage change. To calculate the change over a longer period
of time, select the base year. For each line item, divide the amount in each non base year
by the amount in the base year and multiply by 100.

Figure: Analysis through comparison (Source: Sinha, 2009).

C. Ratio analysis: Ratio Analysis is used to get a fast indication of a firm's financial
performance in major areas. It is a process of determining and interpreting numerical
 relationship based on financial statement. It is a technique of interpretation of financial
statement with the help of accounting ratios derived from the balance sheet and profit and
loss account. The ratios are categorized as Short-term Solvency Ratios, Debt Management
Ratios, Asset Management Ratios, Profitability Ratios, and Market Value Ratios.
D. Funds flow analysis: Fund flow analysis is associated with more specific information as
compared to the wide range of ratio metrics. Fund flow analysis reveals information about
the inflows and outflows of capital for a specific period of time. Fund flow analysis may
disclose why certain ratio valuations are relatively high or low in a company by digging
down into the actual movement of cash and assets into and out of a company. Fund flow
analysis involves creating fund flow statements that match capital inflows with outflows.
E. Cash flow analysis: Cash flow statement represents inflow and outflow of funds. It is
important tool for short term analysis.

Advantages

Financial statement analysis is an important business practice because it facilitates senior

management to reassess a corporation's balance sheet and income statement to estimate levels of
monetary position and success. Financial statement analysis may be essential for management to
recognize levels of cash receipts and disbursements in business operations. A statement of cash
flows lists cash flows related to operating activities, investments and financing transactions. A
statement of owners' equity may facilitate an investor to recognize a company's shareholders.

Major characteristics to improve the financial statements:

1. Intelligibility which indicates that the information contained in financial statements

should be accessible in such a way that users can comprehend it, so they could
communicate the intended meaning. Will statements be understandable or not depends
on how they are compiled by accountants, and how they are used by the users (decision
makers), who should have the basic knowledge to interpret information and to use them
for adoption and implementation of certain business activities.
2. Comparability: To decide the trend of changes in financial situation and to determine
productivity of business enterprises, it is imperative through consistent adherence to
evaluation and measurement of the effects of business events from period to period. This
characteristic should allow investors, creditors and others to identify and appreciate
financial statements of entities in the flow of time, and to compare the financial statements
of different entities (Stanovcic,. 298). At last, comparability of financial statements is
 provided if the users are timely informed about the changes in accounting policy in the
same or in different companies.
3. Timeliness: It entails that if company want that instruments of financial reporting had a
great use value, especially for decision-makers they must be submitted to a reasonable
time.
4. Verifiability: This characteristic is a new attribute from 2010 Framework. The information
is confirmable in the sense that it should ensure credibility and objectivity. It necessitates
that independent observers reach the same or similar conclusions that is not biased or
contains material errors and recognition of the chosen method of assessment is applied
free from material error and subjectivity (Škarić, Jovanović, K., 6).

Limitations Of Financial Statement Analysis

1. It is just study of temporary reports.

2. It checks just financial aspect of company's performance and position but it ignores non-
monetary characteristic of company.
3. It does not investigate the changes in price level of different items of financial statements.
4. Many accounting theories and conventions are used to prepare financial statement and
these concepts and conventions are established for analysis. So, analysis is totally affected
with these accounting concepts.
5. Analysis of financial statements is just source but not conclusion or result because
reviewer or evaluator, who writes its analysis, may also affect the analysis. So, different
interpretation by different person may become its restraint.

It can be said that in financial statements, there is lack of Precision, lack of Exactness, Incomplete
Information, hiding of Real Position or Window Dressing, lack of Comparability, and there is
historical cost.

To summarize, financial statement analysis is helpful in appraising the operational competence

of the management of a company. The actual performance of the company which are divulged in
the financial statements can be compared with some standards set earlier and the any difference
between standards and actual performance can be used as the marker of effectiveness of the
management. Briefly, financial statement analysis is the analysis, interpretation and comparison
of monetary data in order to accomplish desired results.
 Financial Statement Analysis

It is an analysis which highlights important relationships in the financial statements. It focuses on

evaluation of past operations as revealed by the analysis of basic statements.
Overview of Financial Statement Analysis

Financial statement analysis involves gaining an understanding of an organization's financial

situation by reviewing its financial reports. The results can be used to make investment and
lending decisions. This review involves identifying the following items for a company's
financial statements over a series of reporting periods:

• Trends. Create trend lines for key items in the financial statements over multiple time periods,
to see how the company is performing. Typical trend lines are for revenue, the gross margin,
net profits, cash, accounts receivable, and debt.

• Proportion analysis. An array of ratios are available for discerning the relationship between the
size of various accounts in the financial statements. For example, one can calculate a company's
quick ratio to estimate its ability to pay its immediate liabilities, or its debt to equity ratio to
see if it has taken on too much debt. These analyses are frequently between the revenues and
expenses listed on the income statement and the assets, liabilities, and equity accounts listed
on the balance sheet.

Financial statement analysis is an exceptionally powerful tool for a variety of users of financial
statements, each having different objectives in learning about the financial circumstances of the
entity.

Users of Financial Statement Analysis

There are a number of users of financial statement analysis. They are:

• Creditors. Anyone who has lent funds to a company is interested in its ability to pay back the
debt, and so will focus on various cash flow measures.

• Investors. Both current and prospective investors examine financial statements to learn about a
company's ability to continue issuing dividends, or to generate cash flow, or to continue
growing at its historical rate (depending upon their investment philosophies).
• Management. The company controller prepares an ongoing analysis of the company's financial
results, particularly in relation to a number of operational metrics that are not seen by outside
entities (such as the cost per delivery, cost per distribution channel, profit by product, and so
forth).

• Regulatory authorities. If a company is publicly held, its financial statements are examined by
the Securities and Exchange Commission (if the company files in the United States) to see if its
statements conform to the various accounting standards and the rules of the SEC.

Methods of Financial Statement Analysis

There are two key methods for analyzing financial statements. The first method is the use of
horizontal and vertical analysis. Horizontal analysis is the comparison of financial information
over a series of reporting periods, while vertical analysis is the proportional analysis of a
financial statement, where each line item on a financial statement is listed as a percentage of
another item. Typically, this means that every line item on an income statement is stated as a
percentage of gross sales, while every line item on a balance sheet is stated as a percentage of
total assets. Thus, horizontal analysis is the review of the results of multiple time periods, while
vertical analysis is the review of the proportion of accounts to each other within a singl e period.

The second method for analyzing financial statements is the use of many kinds of ratios. Ratios
are used to calculate the relative size of one number in relation to another. After a ratio is
calculated, you can then compare it to the same ratio calculated for a prior period, or that is
based on an industry average, to see if the company is performing in accordance with
expectations. In a typical financial statement analysis, most ratios will be within expectations,
while a small number will flag potential problems that will attract the attention of the reviewer.
There are several general categories of ratios, each designed to examine a different aspect of a
company's performance.

Problems with Financial Statement Analysis

While financial statement analysis is an excellent tool, there are several issues to be aware of
that can interfere with the interpretation of the analysis results. These issues are:

• Comparability between periods. The company preparing the financial statements may have
changed the accounts in which it stores financial information, so that results may differ from
 period to period. For example, an expense may appear in the cost of goods sold in one period,
and in administrative expenses in another period.

• Comparability between companies. An analyst frequently compares the financial ratios of different
companies in order to see how they match up against each other. However, each company may
aggregate financial information differently, so that the results of their ratios are not really
comparable. This can lead an analyst to draw incorrect conclusions about the results of a
company in comparison to its competitors.

• Operational information. Financial analysis only reviews a company's financial information, not
its operational information, so you cannot see a variety of key indicators of future performance,
such as the size of the order backlog, or changes in warranty claims. Thus, financial analysis
only presents part of the total picture.

Objectives of Financial Statement Analysis

1. Assessment of past performance and current position

2. Prediction of net income and growth prospects

3. Prediction of bankruptcy and failure

4. Loan decision by financial institutions and banks

Objectives of Financial Statement Analysis:

The major objectives of financial statement analysis are to provide decision makers information
about a business enterprise for use in decision-making. Users of financial statement information are
the decision-makers concerned with evaluating the economic situation of the firm and predicting
its future course. Financial statement analysis can be used by the different users and decision makers
to achieve the following objectives:
1. Assessment of Past Performance and Current Position: Past performance is often a good
indicator of future performance. Therefore, an investor or creditor is interested in the trend of past
sales, expenses, net income, cash flow and return on investment. These trends offer a means for
judging management’s past performance and are possible indicators of future performance.
Similarly, the analysis of current position indicates where the business stands today. For instance,
the current position analysis will show the types of assets owned by a business enterprise and the
different liabilities due against the enterprise. It will tell what the cash position is, how much debt
the company has in relation to equity and how reasonable the inventories and receivables are.
2. Prediction of Net Income and Growth Prospects: The financial statement analysis helps in
predicting the earning prospects and growth rates in the earnings which are used by investors while
comparing investment alternatives and other users interested in judging the earning potential of
business enterprises. Investors also consider the risk or uncertainty associated with the expected
return. The decision makers are futuristic and are always concerned with the future. Financial
statements which contain information on past performances are analyzed and interpreted as a basis
for forecasting future rates of return and for assessing risk.
3. Prediction of Bankruptcy and Failure: Financial statement analysis is a significant tool in
predicting the bankruptcy and failure probability of business enterprises. After being aware about
probable failure, both managers and investors can take preventive measures to avoid/minimise
losses. Corporate managements can effect changes in operating policy, reorganize financial
structure or even go for voluntary liquidation to shorten the length of time losses. In accounting and
finance area, empirical studies conducted have suggested a set of financial ratios which can give
early signal of corporate failure. Such a prediction model based on financial statement analysis is
useful to managers, investors and creditors. Managers may use the ratios prediction model to assess
the solvency position of their firms and thus can take appropriate corrective actions. Investors and
shareholders can use the model to make the optimum portfolio selection and to bring changes in
the investment strategy in accordance with their investment goals. Similarly, creditors can apply the
prediction model while evaluating the creditworthiness of business enterprises.
4. Loan Decision by Financial Institutions and Banks: Financial statement analysis is used by
financial institutions, loaning agencies, banks and others to make sound loan or credit decision. In
this way, they can make proper allocation of credit among the different borrowers. Financial
statement analysis helps in determining credit risk, deciding terms and conditions of loan if
sanctioned, interest rate, maturity date etc.

However, objectives of financial statements analysis may be stated to bring out the significance of
such analysis:
(i) To assess the earning capacity or profitability of the firm.
(ii) To assess the operational efficiency and managerial effectiveness.
(iii) To assess the short term as well as long term solvency position of the firm.
(iv) To identify the reasons for change in profitability and financial position of the firm.
(v) To make inter-firm comparison.
(vi) To make forecasts about future prospects of the firm.
(vii) To assess the progress of the firm over a period of time.
(viii) To help in decision making and control.
(ix) To guide or determine the dividend action.
(x) To provide important information for granting credit.

IMPORTANCE OF ANALYSIS OF FINANCIAL STATEMENT

Financial statement is prepared at a certain point of time according to established convention. These
statements are prepared to suit the requirement of the proprietor. For measuring the financial
soundness, efficiency, profitability and future prospects of the concern, it is necessary to analyze the
financial statement. Following purposes are served by the Financial analysis: -
Help in Evaluating the operational efficiency of the Concern:- It is necessary to analyze the
financial statement for matching the total expenses incurred in manufacturing, Advertising, selling
and distribution of the finished goods and total financial expanses of the current year comparing
with the total expanses of the previous year and evaluate the managerial efficiency of concern.
Help in Evaluating the short and long term financial position:- It is necessary to analyze the
financial statement for comparing the current assets and current liabilities to evaluate the short term
and long term financial soundness.
Help in calculating the profitability:- It is necessary to analyze the financial statement to know the
gross profit and net profit.
Help in indicating the trend of achievements:- Analysis of financial statement helps in comparing
the Financial position of previous year and also compare various expenses, purchases and sales
growth, gross and net profit. Cost of goods sold, total value of assets and liabilities can be compare
easily with the help of Analysis of financial statement.
Forecasting, budgeting and deciding future line of action:-The potential growth of the business
can be predicts by the analysis of financial statement which helps in deciding future line of action.
Comparisons of actual performance with target show all the shortcomings.

Techniques of Financial Statement Analysis

The more widely used techniques are:

1. Horizontal analysis – Comparative Financial Statements

2. Vertical analysis – Common size Financial Statements

 3. Trend Analysis

4. Ratio Analysis

5. Funds Flow Analysis

6. Cash Flow Analysis

1. Horizontal analysis – Comparative Financial Statements

The percentage analysis of increases and decreases in corresponding items in comparative financial
statements is called horizontal analysis. It involves the computation of amount changes and
percentage changes from the previous year to the current year. The amount of each item on the most
recent statement is compared with the corresponding item on one more earlier statements. The
increase or decrease in the amount of the item is then listed, together with the per cent of increase
or decrease. When the comparison is made between two statements, the earlier statement is used as
the base. If the horizontal analysis includes three or more statements, there are two alternatives in
the selection of the base. First, the earliest date or period may be used as the basis for comparing all
later dates or periods; or second, each statement may be compared with the immediately preceding
statement.

Percentage change = Amount of change X 100

Previous year amount

Comparative Income Statement:

Problem 1:

The income statements of a concern are given for the years ending on 31st Dec 2016 and 2017.

You are required to prepare a comparative income statement and interpret the changes.
Income Statement of ABC Company Ltd. for the years ended Dec. 31, 2016 and 2017

Particulars 2016 2017

(Rs.) (Rs.)

Sales 6,50,000 7,25,000

Cost of sales 4,25,000 5,00,000

Gross Profit 2,25,000 2,25,000

Operating expenses:

Selling & Distribution expenses 60,000 75,000

General expenses 25,000 40,000

Total Operating expenses 85,000 1,15,000

Net Profit during the year 1,40,000 1,10,000

Solution

Comparative Income Statement of ABC Company Ltd. for the years ended Dec. 31 2016

and 2017

Particulars 31st December Increase or Increase or

2016 2017 decrease in decrease in

(Rs.) (Rs.) amounts percentage
(Rs.) (Rs.)
Net sales 6,50,000 7,25,000 +75,000 +11.54

Cost of goods sold 4,25,000 5,00,000 +75,000 +17.65

Gross Profit 2,25,000 2,25,000 - -

Operating expenses:

Selling & Distribution expenses 60,000 75,000 +15,000 +25.00

General expenses 25,000 40,000 +15,000 +60.00

Total Operating expenses 85,000 1,15,000 +30,000 +35.29

Operating profit 1,40,000 1,10,000 -30,000 -21.43

 Comparative Balance Sheet:

Problem 2:

From the following balance sheet of ABC Company Ltd., prepare a comparative balance sheet
and comment on the financial position of the concern.

Balance Sheet of ABC Company Ltd. as on Dec. 31 2016 and 2017

Liabilities 2016 2017 Assets 2016 2017

(Rs.) (Rs.) (Rs.) (Rs.)

Equity shares 2,20,000 2,50,000 Buildings 1,40,000 1,70,000

Debentures 1,00,000 1,20,000 Machinery 1,20,000 1,50,000

Reserves & Surplus 60,000 80,000 Furniture 60,000 40,000

Sundry Creditors 40,000 25,000 Sundry Debtors 40,000 60,000

Bills Payable 35,000 40,000 Marketable securities 55,000 30,000

Outstanding expenses 20,000 - Stock 40,000 55,000

Cash Balance 20,000 10,000

4,75,000 5,15,000 4,75,000 5,15,000

Solution

Comparative Balance Sheet of ABC Company Ltd. as on Dec. 31 2016 and 2017
 Particulars 31st December Increase or Increase or

2016 2017 decrease in decrease in

(Rs.) (Rs.) amounts percentage
(Rs.) (Rs.)

Assets

A. Current Assets

Sundry Debtors 40,000 60,000 +20,000 +50.00

Marketable securities 55,000 30,000 -25,000 -45.45

Stock 40,000 55,000 +15,000 +37.50

Cash Balance 20,000 10,000 -10,000 -50.00

Total (A) 1,55,000 1,55,000 - -

B. Fixed Assets

Buildings 1,40,000 1,70,000 +30,000 +27.43

 Machinery 1,20,000 1,50,000 +30,000 +25.00

Furniture 60,000 40,000 -20,000 -33.00

Total (B) 3,20,000 3,60,000 +40,000 +12.50

Total (A+B) 4,75,000 5,15,000 40,000 8.42

Liabilities

C. Current Liabilities

Sundry Creditors 40,000 25,000 -15,000 -37.50

Bills Payable 35,000 40,000 +5,000 +14.29

Outstanding expenses 20,000 - -20,000 -100.00

Total (C) 95,000 65,000 -30,000 -31.58

D. Long-term Liabilities

Equity shares 2,20,000 2,50,000 +30,000 13.64

Debentures 1,00,000 1,20,000 +20,000 20.00

Reserves & Surplus 60,000 80,000 +20,000 33.33

Total (D) 3,80,000 4,50,000 +70,000 18.42

Total Liabilities (C+D) 4,75,000 5,15,000 +40,000 8.42

 Objectives of comparative financial statements
• Changes taken place in the financial performance are taken into consideration for further
analysis
• To reveal qualitative information about the firm in terms of solvency, liquidity profitability and
so on are extracted from the analysis of financial statements
• With reference to yester financial data of the enterprise, the firm is facilitated to undergo for the
preparation of forecasting and planning.
The major part of financial statement analysis is mainly focused on the comparative analysis.

The comparative analysis classified into four different analyses viz

• Comparative Balance sheet

• Comparative Profit and Loss account
• Common Size statement
• Trend percentage
First we will discuss the comparative Balance sheet.The first and foremost important step is to have
the following information and should take preparatory steps

1. While preparing the comparative statement of balance sheet, the particulars for the financial
factors are required
2. The second most important for the preparation of the comparative balance sheet is yester
financial data extracted from the balance sheet or balance sheets
3. The next most important requirement to have an effective comparison with the yester financial
data is current year information extracted from the balance sheet or balance sheet of the firms.
4. After having been procured the financial data pertaining to various time periods are ready for
comparison; to determine or identify the level of increase or decrease taken place in the financial
position of the firms
5. To determine the level of increase or decrease in financial position, the percentage analysis to
carried out in between them.
Illustration
From the following information, Prepare comparative Balance sheet of X Ltd.
 The first step we have to segregate the available information into two different categories viz Assets
and Liabilities

N. C = No change in the position during the two years

From the above table, the following are basic inferences

• The fixed assets volume got increased 20% from the year 2004 to 2005, amounted Rs. 12, 00, 000
• Rs 9, 00, 000 worth of current assets decrease from the year 2004 to 2005 recorded 30%
• The total volume of assets recorded 3% increase from the year 2004 to 2005
• It obviously understood that 20% increase taken place on the reserves and surpluses
• It clearly evidenced that the current liabilities of the firm increased 10% from the year 2004 to
2005
• The firm has not recorded any changes in the investments, equity share capital and long-term
loans
The next one in the comparative financial statement analysis is that Income statement analysis

Comparative (Income) financial statement analysis: This analysis is being carried out in between the
income statements of the various accounting durations of the firm, with other firms in the industry
and with the industrial average.

This will facilitate the firm to know about the stature of itself regarding the financial performance.
It facilitates to understand about the changes pertaining to various financial data which closely
relevantly connected with the financial performance

• Change in the gross sales

• Change in the net sales
• Change in gross profit and net profit
• Change in operating profit
• Change in operating expenses
• Change in the volume of non operating income
• Change in the non operating expenses
The ultimate purpose of the comparative (Income) financial statement analysis is as follows

1. To study the income earning and expenditure spending pattern of the firm for two or more years
2. To identify the changing pattern of the income and expenditure of the firms. The preparatory
steps for the preparation of the comparative financial statement (Income) analysis
The first and foremost important step is to have the following information and should take
preparatory steps

1. While preparing the comparative statement of Profit and Loss Account, the particulars for the
financial factors are required
2. The second most important for the preparation of the comparative Profit & Loss account is yester
financial data extracted from the Profit & Loss A/c or Profit & Loss Accounts
3. The next most important requirement to have an effective comparison with the yester financial
data is current year information extracted from the balance sheet of the firm or of the other firms
4. After having been procured the financial data pertaining to various time periods are ready for
comparison; to determine or identify the level of increase or decrease taken place in the operating
financial performance of the firms
5. To determine the level of increase or decrease in financial performance, the percentage analysis
to be carried out in between them.
Illustration
Prepare the comparative income statement from the following:
 From the above table, the following inferences can be had: Financial Statement Analysis

• The firm has registered 25% increase in sales from the year 2004 to 2005
• Cost of goods sold raised 30% from the year 2004 to 2005
• There is no change in the level of operating expenses
• The firm has got 22. 22% increase in the level of net profits from the year 2004 to 2005
Illustration
From the following information, prepare a comparative income statement:

For this problem, the inferences could be enlisted according to the comparative statement analysis
on Profit & Loss Accounts of two different year viz 2001 and 2002.

The next important tool of financial statement analysis is a common size statement analysis which
known as predominant tool in intra firm analysis in studying the share of each component.
The components are translated into percentage for analysis and interpretations. For profit and loss
account, Net sales is considered as a base for the computation of a share of each financial factor
available.
For Balance sheet, total volume of assets and liabilities are taken into consideration for the
computation of a share of each financial factor available under the heading of assets and liabilities.
Illustration
Prepare the common size statement analysis for the firm ABC ltd

The above illustration highlights the share of every component in the balance sheet out of the total
volume of assets and liabilities.

This will certainly facilitate the firm to easily understand not only the share of every component but
also facilitates to have a meaningful and relevant comparison with various time horizons.
From the following table, prepare the common size statement analysis:

2. Vertical analysis – Common Size Financial Statements

One of the simplest ways of understanding a financial statement is to examine the relationship of
the various components forming part of the total, to such total. This enables us to understand the
relative importance of each individual component. A financial statement presented by
representing each item as a percentage to the total amount of which it is a part, is referred to as a
“common size financial statement”. Since the magnitude of absolute numbers is removed, it
becomes comparatively easy to understand. When we say that company X has a sale of Rs. 15
crore during the year and the cost of goods sold was Rs. 12 lakh, compared with company Y,
which had a sale of Rs. 8 million and its cost of goods sold was Rs. 4.8 million, it is not amenable
 to direct understanding. If we represent the same information about companies X and Y as sales
100 and cost of goods sold of X as 80% of sales and Y’s as 60% of sales, the understanding is more
direct and easy. Whenever we have to deal with many companies in the same industry, common
size statement becomes a very useful tool for a preliminary review of the statements.

Common Size Profit & Loss Account

The profit & loss account summarizes the revenues and expenses of an accounting period.

Common size profit & loss account can be prepared as a percentage of the net sales.

Common Size Balance Sheet

A common size balance sheet is constructed by showing each item of asset as a percentage of the
total assets, and similarly, each item of liability and owner’s equity is shown as a percentage of
the total liabilities and owner’s equity.
Common size analysis, also referred as vertical analysis, is a tool that financial managers use to
analyze financial statements. It evaluates financial statements by expressing each line item as a
percentage of the base amount for that period. The analysis helps to understand the impact of each
item in the financial statement and its contribution to the resulting figure.
The technique can be used to analyze the three primary financial statements, i.e., balance sheet,
income statement and cash flow statement. In the balance sheet, the common base item to which
other line items are expressed is total assets, while in the income statement, it is total revenues.

Types of Common Size Analysis

Common size analysis can be conducted in two ways, i.e., vertical analysis and horizontal analysis.
Vertical analysis refers to the analysis of specific line items in relation to a base item within the same
financial period. For example, in the balance sheet, we can assess the proportion of inventory by
dividing the inventory line using total assets as the base item.

On the other hand, horizontal analysis refers to the analysis of specific line items and comparing it
to a similar line item in the previous or subsequent financial period. Although common size analysis
is not as detailed as trend analysis using ratios, it does provide a simple way for financial managers
to analyze financial statements.
Balance Sheet Common Size Analysis

The balance sheet common size analysis mostly uses the total assets value as the base value. On the
balance sheet, the total assets value equals the value of total liabilities and shareholders’ equity. A
financial manager or investor uses the common size analysis to see how a firm’s capital structure
compares to rivals. They can make important observations by analyzing specific line items in
relation to the total assets.

For example, if the value of long-term debts in relation to the total assets value is too high, it shows
that the company’s debt levels are too high. Similarly, looking at the retained earnings in relation to
the total assets as the base value can reveal how much of the annual profits are retained on the
balance sheet.

Let’s take the example of ABC Company whose balance sheet for 2017 is as follows:
From the table above, we can deduce that cash represents 14.5% of the total assets while inventory
represents 12% of the total assets. In the liabilities section, we can deduce that accounts payable
represent 15%, salaries 10%, long-term debt 30%, and shareholder’s equity 40% of the total liabilities
and stockholder’s equity.

Income Statement Common Size Analysis

The base item in the income statement is usually the total sales or total revenues. Common size
analysis is used to calculate net profit margin, as well as gross and operating margins. The ratios
tell investors and finance managers how the company is doing in terms of revenues, and they can
make predictions of future revenues. Companies can also use this tool to analyze competitors to
know the proportion of revenues that goes to advertising, research and development, and other
essential expenses.

We can compute common size income statement analysis for ABC Company for 2017.

By looking at this income statement, we can see that in 2017, the amount of money that the company
invested in research and development (10%) and advertising (3%). The company also pays interest
to the shareholders, which is 2% of the total revenue for the year. The net operating income or
earnings after interest and taxes represent 10% of the total revenues, and it shows the health of the
business’s core operating areas. The net income can be compared to the previous year’s net income
to see how the company’s performance year-on-year.
Importance of Common Size Analysis

One of the benefits of using common size analysis is that it allows investors to identify drastic
changes in a company’s financial statement. It mainly applies when the financials are compared
over a period of two or three years. Any significant movements in the financials across several years
can help investors decide whether to invest in the company. For example, large drops in the
company’s profits in two or more consecutive years may indicate that the company is going through
financial distress. Similarly, considerable increases in the value of assets may mean that the
company is implementing an expansion or acquisition strategy, making the company attractive to
investors.

Common size analysis is also an excellent tool to compare companies of different sizes but in the
same industry. Looking at their financial data can reveal their strategy and their largest expenses
that give them a competitive edge over other comparable companies. For example, some companies
may sacrifice margins to gain a large market share, which increases revenues at the expense of profit
margins. Such a strategy allows the company to grow faster than comparable companies because
they are more preferred by investors.
Problem 3:
Common size Profit & Loss Account of XYZ Ltd. for the year ended December 31, 2017

Particulars 2017 2016

Rs. In million % Rs. In million %

Sales 300 100 280 100

Cost of goods sold 148 49.33 140 50.00

Gross profit 152 50.67 140 50.00

Selling expenses 25 8.33 22 7.86

General expenses 60 20.00 58 20.71

Total operating expenses 85 28.33 80 28.57

Operating income 67 22.33 60 21.43

Interest expenses 14 4.67 13 4.64

Net income before tax 53 17.67 47 16.79

Income tax 26 8.67 23 8.21

Profit tax 27 9.00 24 8.57

Dividends 2 0.67 2 0.71

Profit retained 25 8.33 22 7.86

Problem 4:

Common size Balance Sheet of XYZ Ltd. as on December 31, 2017

2017 2016

Rs. In million % Rs. In million %

Assets

Cash 19 5.76 11 4.07

Accounts receivable 32 9.70 20 7.41

Loans and advances 43 13.03 34 12.59

Inventory 121 36.67 99 36.67

Other current assets 17 5.15 26 9.63

Total current assets 232 70.31 190 70.37

Fixed Assets (net) 94 28.48 79 29.26

Other assets 4 1.21 1 0.37

Total assets 330 100.00 270 100.00

Liabilities & Capital

Current Liabilities:

Acceptances 5 1.52 2 0.74

Accounts payable 27 8.18 19 7.04

Advance against sales 26 7.88 21 7.78

Other liabilities 9 2.73 8 2.96

Interest accrued 3 0.90 2 0.74

Total current liabilities 70 21.21 52 19.26

Provisions:
Provisions for taxation 26 7.88 21 7.77

Provisions for proposed 2 0.61 2 0.74

dividends

Provisions for bonus 3 0.90 2 0.74

Provisions for others 4 1.21 3 1.11

Total provisions 35 10.61 28 10.37

Total current liabilities and 105 31.82 80 29.63

provisions

Long term liabilities

Bank term loans 40 12.12 32 11.85

10.5% Debentures 26 7.88 26 9.63

Financial institutions 24 7.27 22 8.15

Total long term liabilities 90 27.27 80 29.63

Total liabilities 195 59.08 160 59.26

Shareholders’ equity
 Paid up capital 37 11.21 37 13.70

Retained earnings 98 29.70 73 27.04

Total shareholders’ equity 135 40.91 110 40.74

Total liabilities & 330 100.00 270 100.00

Shareholders’ Equity

Trend Analysis

The financial statements may be analysed by computing trends of series of information. Trend
analysis determines the direction upwards or downwards and involves the computation of the
percentage relationship that each item bears to the same item in the base year. In case of comparative
statement, an item is compared with itself in the previous year to know whether it has increased or
decreased or remained constant. Common size analysis is to ascertain whether the proportion of an
item (say cost of revenue from operations) is increasing or decreasing in the common base (say
revenue from operations). But in case of trend analysis, we learn about the behaviour of the same
item over a given period, say, during the last 5 years. Take for example, administrative expenses,
whether they are exhibiting increasing tendency or decreasing tendency or remaining constant over
the period of comparison. Generally trend analysis is done for a reasonably long period. Many
companies present their financial data for a period of 5 or 10 years in various forms in their annual
reports.
Procedure for Calculating Trend Percentage
One year is taken as the base year. Generally, the first year is taken as the base year. The figure of
base year is taken as 100. The trend percentages are calculated in relation to this base year. If a figure
in other year is less than the figure in base year, the trend percentage will be less than 100 and it will
be more than 100 if figure is more than the base year figure. Each year’s figure is divided by the base
year figure. The accounting procedures and conventions used for collecting data and preparation
of financial statements should be similar; otherwise the figures will not be comparable.
 Trend analysis involves the collection of information from multiple time periods and plotting
the information on a horizontal line for further review. The intent of this analysis is to spot
actionable patterns in the presented information. In business, trend analysis is typically used
in two ways, which are as follows:

• Revenue and cost analysis. Revenue and cost information from a company's income statement
can be arranged on a trend line for multiple reporting periods and examined for trends and
inconsistencies. For example, a sudden spike in expense in one period followed by a sharp
decline in the next period can indicate that an expense was booked twice in the first month.
Thus, trend analysis is quite useful for examining preliminary financial statements for
inaccuracies, to see if adjustments should be made before the statements are released for
general use.

• Investment analysis. An investor can create a trend line of historical share prices, and use this
information to predict future changes in the price of a stock. The trend line ca n be associated
with other information for which a cause-and-effect relationship may exist, to see if the causal
relationship can be used as a predictor of future stock prices. Trend analysis can also be used
for the entire stock market, to detect signs of a impending change from a bull to a bear market,
or the reverse.

When used internally (the revenue and cost analysis function), trend analysis is one of the most
useful management tools available. The following are examples of this type of usage:

• Examine revenue patterns to see if sales are declining for certain products, customers, or sales
regions.

• Examine expense report claims for evidence of fraudulent claims.

• Examine expense line items to see if there are any unusual expenditures in a reporting period
that require additional investigation.

• Extend revenue and expense line items into the future for budgeting purposes, to estimate
future results.

When trend analysis is being used to predict the future, keep in mind that the factors formerly
impacting a data point may no longer be doing so to the same extent. This means that an
extrapolation of a historical time series will not necessarily yield a valid prediction of the
future. Thus, a considerable amount of additional research should accompany trend analysis
when using it to make predictions.
Management Discussion and Analysis

The Management Discussion and Analysis is a part in a company's annual report were senior

management addresses company performance and productivity. The Management Discussion and

Analysis (MD&A) part of a company's annual report explains company performance and

productivity. This is generally undertaken by senior management and bsuiness analystsa that are

tasked with analysing the company's performance through both qualitative and quantitative data.

Whilst all sections of an annual report unveil useful information, the MD&A is crucial. The MD&A
tells shareholders the reasons why a company is healthy, or the reasons why it's not. The MD&A
interprets the numbers in the financial statements; it details operational tactics and the management
style that has led the company to its current state. It outlines future goals and looks ahead to new
projects. Fundamental analysts should review a company's Management Discussion and Analysis
when considering an investment opportunity. Investors need to remember that this section is
unaudited, unlike the financial statements.

As well as providing commentary on financial statements, the MD&A will also comment on
compliance with laws and regulations, systems and controls, as well as actions that have been
planned in order to tackle any obstacles the business may be facing. In America, it is just one of
many sections required by the Securities and Exchange Commission (SEC) and the financial
Accounting Standards Board (FASB) to be included in a public company’s annual report to
shareholders. This allows any potential investors to understand the company’s financial
fundamentals and management's thinking, beliefs, and performance.

Key Aspects of the Management Discussion and Analysis

These are just three key areas of the MD&A, and organizations will add many more depending on
their line of business.
Critical Accounting Estimates
In order for investors to fully understand the effects of accounting policies and any judgements
made when implementing the policies, the SEC encourages companies to fully divulge their
accounting policies within their MD&A.
Liquidity and Capital Resources
Part of the MD&A is management's responsibility to identify any known trends, events, demands,
or uncertainties that are likely to result in material changes in liquidity or capital resources. This
area of the report should also include information on the company's material commitments for
capital expenditures and any anticipated sources of funds to meet such commitments.
Results of Operations
When reporting on the results of operations, the management must focus on unusual events or
transactions and any significant economic changes that have affected income from continuing
operations. Any trends or uncertainties that have occurred or that they expect to have an impact on
the net revenues from operations, whether it be positive or negative, must be explained. In the case
of the company having a significant rise in sales or revenues compared to previous periods
management must ascertain the degree to which the increase is attributed to operational change,
the introduction of a new product or service, a price increase, or to some other factors.