“ METHODS OF FINANCIAL STATEMENT ANALYSIS ’’

The final draft is submitted for the partial fulfilment of (B.B.A.L.L.B) course
Titled
Accounting and Auditing

Submitted to :
Mr. Ashok Kumar Sharma
Assistant Professor
Submitted by :
Mahima Kumari
Roll no. – 23227
B.B.A.L.L.B(Hons.)
Semester – 1st
Session – 2023-2028

SEPTEMBER 2023
CHANAKYA NATIONAL LAW UNIVERSITY, PATNA

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Contents
1.INTRODUCTION .............................................................................................................................. 5
2.METHODS OF FINANCIAL STATEMENT ANALYSIS ............................................................................. 8
3.HORIZONTAL AND VERTICAL ANALYSIS ............................................................................................ 8
3.1 KEY DIFFERENCE – HORIZONTAL VS VERTICAL ANALYSIS ........................................................... 9
3.2 VERTICAL VS. HORIZONTAL ANALYSIS ..................................................................................... 11
4.COMPARATIVE FINANCIAL STATEMENTS ........................................................................................ 14
4.1 CASH FLOW STATEMENTS ....................................................................................................... 15
4.2INCOME STATEMENTS ............................................................................................................. 15
4.3 COMPARATIVE STATEMENT EXAMPLE..................................................................................... 15
5.RATIO ANALYSIS ............................................................................................................................ 16
6.TREND ANALYSIS ........................................................................................................................... 20
7.CONCLUSION ................................................................................................................................ 21
8.BIBLIOGRAPHY.............................................................................................................................. 21

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ACKNOWLEDGEMENT
I take this opportunity to express my sincere gratitude and deep regards to my guide, mentor
Mr. Ashok Kumar Sharma, Assistant Professor of Management, for his exemplary guidance,
monitoring and constant encouragement throughout the project.
His blessing, help, and guidance from time to time shall carry the researcher a long way in
the journey of life on which the researcher is about to embark.
The success and outcome of this project required a lot of guidance and assistance from many
people, and I am highly privileged to have gotten this all along with the completion of this
project. Last but not the least, I am thankful to all the members of my family, friends and
teachers, without their assistance and encouragement, I could not have been able to complete
my submission.
Mahima Kumari
Roll no - 23227

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DECLARATION
I, Mahima Kumari, hereby declare that the work reported in the B.B.A.L.L.B (Hons.) project
titled Methods of Financial Statement Analysis submitted at Chanakya National Law
University, Patna is an authentic record of my work carried out under the supervision of Mr.
Ashok Kumar Sharma.
I have not submitted this work elsewhere for any other degree or diploma, and I am fully
responsible for the content of my project report.
Mahima Kumari (23227)
B.B.A.L.L.B (Hons.)
First semester

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1.INTRODUCTION

Financial Statement analysis is a method of reviewing and analyzing a company’s accounting

reports ( financial statement ) in order to gauge its past, present and future projected
performance. This process of reviewing the financial statement allows for better economic
decision making. Internal and external stakeholders both utilize financial statement analysis
to assess the worth and performance of an organization. All businesses are required under
financial accounting to produce balance sheets, income statements, and cash flow statements,
which serve as the foundation for financial statement analysis.
Analysts examine financial accounts using three methods : Ration Analysis, Vertical
Analysis, and Horizontal Analysis.
By carefully examining both historical and current financial records, investors and analysts
use ratio analysis to assess a company's financial health.
Vertical analysis is a technique for analyzing financial statements when each line item is
reported as a percentage of a base amount.
Horizontal analysis, often referred to as trend analysis, is the examination of financial
patterns through time that analysts and investors use to assess firms and forecast the effects of
corporate choices.
Therefore, the main purpose of financial statements analysis is to utilize information about
the past performance of the company in order to predict how it will fare in the future. Another
important purpose of the analysis of financial statements is to identify potential problems
areas and troubleshoot those. It is the examination of a company’s financial statement to get
useful data for decision making. In addition to the management, external stakeholders use
financial statements for a variety of purposes. Management and external stakeholders utilize a
variety of techniques to analyze financial statements.

NEED FOR FINANCIAL STATEMENT

To find patterns and connections between financial statement items, financial statements
analysis is employed. A company's profitability, liquidity, and solvency must be assessed by
both internal management and external consumers of the financial statements (such as
analysts, creditors, and investors). Trend analysis is one of the most often utilized techniques
in financial statement analysis. These techniques utilize computation and corporate data,
rivalry, or industry average to ascertain the relative performance and strength of the firm
under analysis. We know that the analysis of financial statement helps the analyst to know the
financial information from the financial data contained in the financial statements and to

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assess the financial health (i.e. strength or weakness) of an enterprise. It also helps to make a
forecast for the future which helps us to prepare budgets and estimates. In short, analysis of
financial statements helps us to take various decisions at various places of a firm. 1

Knowing the causes of relative changes like in profitability or in the financial situation as a
whole helps us. It is also useful to understand a firm’s long term liquidity and solvency
positions as well as its short term liquidity position relative to working capital position and
emphasizes the company’s operational effectiveness and current capability for profit making
as whole.

There are various steps involved in analysis of financial statement : The analysis of financial
statement needs Methodical classification and tools of financial statement analysis. We are
aware that financial statements are often created using a traditional format that does not
provide the data needed by an analyst. In order to properly evaluate and analyze the data, an
analyst rearranges the data and displays and prepares it in a changed form. The said data are
modified in a vertical form for a particular purpose and is not a compulsory requirement but
only as a matter of convenience for understanding and analysis. Thus, there is no standard
form of its presentation which should be applied in all the cases. The financial statements
used may also be prepared without modification; in that case, we cannot use them
conveniently. While in case of methodical presentation, the information may be presented
side by side for the purpose of making proper comparison and understanding. Application of
a single tool is not at all sufficient to assess the financial position of an enterprise. A
combination of some tools should be applied in order to assess the financial position. For
example, if an analyst desires to assess the liquidity position of a firm, he must consider the
ratio analysis (i.e. liquidity ratios) along with the Cash Flow Analysis, Funds Flow Analysis,
and Working Capital Analysis etc. This will help him better to assess the liquidity position of
a firm.

The tools of financial statement analysis are: Comparative Statement, Common-Size

Statement, Trend Analysis, Working Capital Analysis, Funds Flow Analysis, Cash Flow
Analysis, Ratio Analysis, Cost-Volume Profit (CVP)/Break-Even Analysis.

1
Shreya Subho, Analysis of Financial Statement: Need, Objectives and Requisites, Your article Library ( Sept.
13, 2023, 07:51 AM), https://www.yourarticlelibrary.com/accounting/financial-statements-analysis/analysis-of-
financial-statement-need-objectives-and-requisites/73269

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AIM AND OBJECTIVE

1) The main purpose of this study is to determine, forecast and evaluate the best of
economic condition and future performance of a company.
2) To determine whether the business has the capacity to pay back its debts.
3) To determine true and fair view of financial position of a business.
4) To track financial results on a trend line to spot any looking profitability issues.
5) To increase the understandability of the end user.

RESEARCH QUESTION
1) What is Financial Statement Analysis ?
2) What is the need of financial statement analysis?
3) What is difference between vertical analysis and horizontal analysis?
4) What is comparative financial statements?
5) What is ratio analysis?
6) What is trend analysis?

HYPOTHESIS
The researcher presumes that detailed study with example is required to properly study the
financial statement of a company, an organization, a bank or any other institutions with the
help of different methods.

RESEARCH METHODOLOGY
The Researcher will be relying on doctrinal method of research . The Researcher will be
using primary and secondary sources of data.

MODE OF CITATION
The researcher has followed the 20th edition of bluebook for the purpose of citation.

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LIMITATION
The researcher will simultaneously engage in this study with other academic work. This
consequently will cut down on the time devoted to the research work. The unavailability of e-
library and restricted access to other sources also effected the research.

2.METHODS OF FINANCIAL STATEMENT ANALYSIS

Financial statements analysis (FSA) means studyingthe financial statements of a company to

get meaningful information for decision making. Apart from the management, external
stakeholders also carry financial statements analysis for several purpose. These are several
methods of financial statements analysis that management and external stakeholders use. All
these methods vary in calculation and factors used for financial statements analysis, financial
institutions, creditors, lenders, and more do FSA to understand the health of the company,
moreover, these methods provide a summary of data that helps to analyze and interpret
financial data. 2

1.Horizontal and vertical analysis

2.Comparative Financial statements

3. Ratio Analysis

4. Trend Analysis

3.HORIZONTAL AND VERTICAL ANALYSIS

In horizontal analysis, the analyst compare the financial information of one period with the
previous 12 years. In this, we compare a line item with the same line item in another period (a
year or quarter) . The objective is to find any significant change in any line item. For
instance, if the cost of good sold (COGS) rise much more than the increase in sales or gross
profit rises but net profit drops.

2
Finance management, https://efinancemanagement.com/financial-analysis/methods-of-financial-statement-
analysis (last visited sept. 13, 2023)

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In vertical analysis, every line item in the financial statements is calculated as a proportion of
another prominent item. Usually, in the income statements, each line item is calculated as a
proportion of revenue or sales. On the balance sheet, each lime item is represented as a
proportion of revenue or sales. On the balance sheet, each line item is represented as a
proportion of total assets. After the calculation of ratio, one can compare them with the past
years to identify any usual happening.

3.1 KEY DIFFERENCE – HORIZONTAL VS VERTICAL ANALYSIS

Financial statements such as the income statements , balance sheet and Cash flow statement
are important statements that should be studied extensively in order to arrive at conclusion
regarding the performance of the current financial year as well as to assist planning the
upcoming financial year’s budget. Horizontal and vertical analysis are two main types of
analysis methods used for this purpose. The key difference between horizontal and vertical
analysis is that horizontal analysis is a procedure in financial analysis in which the amounts
in financial statements over a certain period of time is compared line by line in order to make
related decisions whereas vertical analysis is the method of analysis of financial statements
where each line item is listed as a precentage of another item. 3

What is Horizontal Analysis?

A Horizontal analysis, also referred to as ‘trends analysis’, is a procedure in the financial

analysis where the amounts of financial information over a certain period of time is compared
line by line in order to make related decisions .

Example

ABC company’s income statement for the year ended

2018 is shown below along with the financial results for

the year 2019.

ABC Company

Income statement for the year ending 31.12.2019

2018($000) 2019($000)

3
Investopedia,https://www.investopedia.com/terms/h/horizontalanalysis.asp (last viewed sept.13 2023)

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 Revenue 5600 6854
Cost of sale (2452) (3010)
Gross profit 3148 (3844)
Administrative experience 275 315
Selling and marketing 520 632
expenses
Operating income 120 125
Operating profit 2233 2772
Tax paid 450 470
Net profit 1783 2302

Horizontal analysis involves comparing financial results line by line horizontally. This assists
understanding how the results have changed from one financial period to another. This can be
calculated in absolute term as well as in percentage term.

What is vertical Analysis?

Vertical analysis is the methods of analysis of financial statements where each line item is
listed as a percentage of another item to conduct useful decision making Here Each line item
on the income statement is expressed as a percentage of sales revenue and each line item on
the balance sheet is expressed as a percentage of total assets. Continuing from the above
example.

E.g. HGY's gross profit margin for 2015 and 2016 is $3, 148m can be calculated as,

Gross profit margin for 2015= $3, 148m/$5600m*100 = 56.2%

Gross profit margin for 2016 = $3, 844/$6, 854m*100 = 56.1%

The comparison between the two ratios indicates that despite the rise in both revenue and cost
of sale, the gross profit has changed only marginally. Financial statements should be prepared
in a standard vertical format in accordance with accounting standards. The main use of
vertical analysis is to calculate the financial ratios which in turn are key metrics in evaluating
company performance. Once the ratios are calculated, they can be easily compared with
ratios in similar companies for benchmarking purpose.

How vertical Analysis work?

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Vertical Analysis makes it much easier to compare the financial statements of one company
with another, and across industries. This is because one can see the relative proportion of
account balances. It also makes it easier to compare previous periods for time series analysis,
in which quaterly and annual figures are compared over a number of years, in order to gain
picture of whether performance metrics are improving or deteriorating. Vertical Analysis is
used in order to gain a picture of whether performance metrics are improving or deteriorating.

3.2 VERTICAL VS. HORIZONTAL ANALYSIS

Another from of financial statements analysis used in ratio analysis is horizontal analysis or
trend analysis. This is whether ratio or line item in a company’s financial statements are
compared over a certain period of time by choosing one year’s worth of entries as a baseline,
while every other year represents percentage difference in terms of changes to that baseline.

Example of vertical Analysis

For example suppose XYZ Corporation has gross sales of $ 5 million and cost of good sold
of $ 1 million and general and administrative expenses of $ 2 million and 25% tax rate, it’s
income statements will look this if vertical analysis is used;

Sales 5000000 100%

Cost of good sold 1000000 20%
Gross profit 4000000 80%
General and Administrative 2000000 40%
expenses
Operating income 2000000 40%
Taxes (%25) 5000000 10%
Net income 15000000 30%

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4.COMPARATIVE FINANCIAL STATEMENTS

This method is similar to the horizontal and vertical analysis, in this method we prepare the
income statements and balance sheet in a way to get a time perspective of the line items. Or
we can say the financial statements show figures of two or more years in a single financial
statements. It makes it easy to compare a line item with the previous years.

What is Comparative Statements ?

A comparative statements is a document used to compare a particular financial statements

with prior period statements. Previous financial are presented alongside the latest figures in
side by side columns, enabling investors to identify trends, track a company’s progress and
compare it with industry rivals.

How comparative statements work?

Analyst, investors, and business manager use a company’s income statements, balance sheet,
and cash flow statements for comparative purposes. They want to see how much is spent
chasing revenues from one period to next and how items on the balance sheet and the
movement of cash vary over time. Comparative statements ,show the effects of business
decision on a company’s bottom line, trend are identified and the performance of the
managers, new lines of business and new products can be evaluated without having to flip
through individual financial statements.

Comparative statements can also be used to compare different companies, assuming that they
follow the same accounting principles,. For example, they can show how different business
operating in the same industry react to market conditions. Reporting just the latest dollar
amounts make it hard to compare the performance of companies of various sizes. Adding
prior period figures, complete with percentage changes, helps to eliminate this problem. The
Securities and Exchange Commission requires public companies to publish comparative
statements . A comparative statements is a document that compare a particular financial
statement with prior period statements. Previous financial are presented alongside the latest
figures in side by side columns enabling investors to easily track a company's progress and

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compare it with peers. The securities and exchange Commission requires public companies to
publish comparative statements.4

4.1 CASH FLOW STATEMENTS

Every business must generate sufficient cash inflows to pay for operations. For example,
manager may compare the ending balance in cash each month over the past two years to
determine if the ending cash balance is increasing or declining. If company sales are growing,
the manufacturer requires more cash to operate each month, which is reflected in the ending
cash balance. A downward trend in the ending cash balance means that the receivable balance
growing and that the firm needs to take step to collect cash faster.

4.2INCOME STATEMENTS

A percentage of sales presentation is often used to generate comparative financial statements

for the income statements- the area of a financial statements dedicated to A company's
revenue and expenses. Presenting each revenue and expenses category as a percentage of
sales makes it easier to compare period and assess company performance.

4.3 COMPARATIVE STATEMENT EXAMPLE

Assume, for example that a manufacturer's cost of goods sold increases from 30% of sales to
45% of sales over three years, management can use that data to make changes, such as
finding more competitive pricing of materials or training employees to lower labour costs. On
the other hand, an analyst may see the cost of sales trend and conclude that the higher costs
make company less attractive to investors.

Comparative statements limitation

Comparative statements are less reliable when companies undergo huge changes,. A big
acquisition and move into new end markets can transform businessess , making them
different entities from previous reporting periods. For example, If A company A acquires
Company B itMay report A sudden sharp jump in sales to account for all the extra revenue

4
Accounting tools, https://www.accountingtools.com/articles/what-are-comparative-financial-statements.html
(last visited sept. 13, 2023)

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that company But generates. At the same time, profit margins might tighten at an alarming
rate because company But has less lean manufacturing process, spending more money to
produce the goods it sells. 5

5.RATIO ANALYSIS

It is among the most popular methods of financial statements analysis. There are different
types of ratio that help management and analyst to dig out meaningful information. There are
four categories of ratio- profitability ratio, liquidity ratio, leverage ratio, and activity ratio,
some of the popular ratio are the current ratio, PE ratio, debt ratio and more.

What is Ratio Analysis ?

Ratio analysis is a quantitative method of gaining insight into a company’s liquidity,

operational, efficiency, and profitability by studying it’s financial statements such as the
balance sheet and income statements. Ratio analysis is cornerstone of fundamental equity
analysis. Ratio analysis compare line item data from a company's financial statements to
reveal insight regarding profitability, liquidity, operational efficiency, and solvency. Ratio
analysis can mark how a company is Performing over time, while comparing a company to
another within the same industry or sector. While ratio offer useful insight into a company,
they should be prepared with other metrics, to obtain a broader pictures of a company's
financial health.

What does Ratio analysis tell?

Investors and analyst employ ratio analysis to evaluate the financial health of companies by
scrutinizing past and current financial statements. Comparative data can demonstrate how a
company is performing over text and can be used to estimate likely future performance. This
data can also compare a company financial standing with industry averages while measuring
how a company stacks up against other with in the same sector. Investors can use ratio

5
Dheeraj Vaidhya, Comparative statement(sept.13,2023 22:06),
https://www.wallstreetmojo.com/comparative-statement/

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analysis easily, and every figure needed to calculate the ratio is found on a company’s
financial statements. Ratio are comparison points for companies. They evaluate stocks within
an industry. Likewise, they measure a company today against it historical numbers. In most
cases, it is also important to understand the variable driving ratio as management has the
flexibilityto, at times, alter it’s strategy to make its stock and company ratio more attractive.
Generally, ratio are typically not use in isolation but rather in combination with other ratio in
each of the four previously mentioned categories will give you a comprehensive view of
company from different angels and help you spot potential red flag. 6

Example of Ratio Analysis Categories

1.Liquidity Ratio

A liquidity ratio is also known as short term solvency these ratios are used to measure the
firms abilitiy to meet short termobligation. They compare short-term obligation to short term
(or current) resources available to meet these obligation. From these ratios much insight can
be obtained into the present cash solvency of the firm and firms abilitiy to remain solvent in
the event of adversity. The creditors of the firm are primarily interested in the short-term
solvency of the firm. A firms liquidity should be neither too high nor too low but adequate.
Low liquidity implies the firms inability to meet its maturing obligations. This will result in
bad credit rating, loss of creditors confidence or even technical insolvency ultimately leading
to the closure of the firm. A very high liquidity position is also bad . It means that the firms
current assets are too high in proportion to maturing obligations. Ideal assets earn nothing to
the firm. The firms funds will be unnecessarily looked up in currents assets, which if,
released can be used to generate profits to the firmThe ratios, which measure, and indicate the
extent of a firms liquidity, are known as liquidity ratios or short-term solvency ratios.
Commonly used liquidity ratios include

• Current ratio (or) working capital ratio

• Quick ratio (or) acid test ratio

• Cash position ratio (or) super stock quick ratio

6
Ratio Analysis, https://www.vedantu.com/commerce/ratio-analysis (last visited sept.13, 2023)

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2. Solvency Ratio

Also called financial leverage ratios, solvency ratio compare a company’s debt levels with its
assets, equity, and earnings, to evaluate the likelihood of a company staying afloat over the
long haul, by paying off its debt. Example of solvency ratio include : debt equity ratio, debt
ratio, and interest coverage ratios.

3. Profitability Ratio

These ratio convey how well a company can generate profits from its operations. Profitability
is the ability to make profit. Every firm should earn adequate profits in order to survive in the
immediate present and grow in future. In fact, profit is what makes the business run.
Profitability is the net result of large number of policies and decisions. Profitability ratio give
final answer about how efficiency the firm is managed. The profitability ratio relates profits
earned by a firm by its parameters like sales, capital employed and net worth. But while
making ratio analysis relating to profits, it should be remembered that there are different
concept of profit such as contribution, gross profits, net profit, EBIT, operating profits, profit
before depreciation and before tax etc. Profitability ratios are important for a concern. These
ratios are calculated to enlighten the end results of business activities, which is the sole
criterion of the overall efficiency of a business concern. The following are the important
profitability ratio, which are based on.

• Sales

• Investment

• Gross profit ratio

• Operating ratio

• Operating profit ratio

• Net profit ratio

• Return on capital employed

• Return on shareholders equity

• Return on total assets

• Earning per share

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• Dividend payout ratio

Activity Ratio

The finances obtained by the firm from its owners and creditors will be invested in assets,
which the firm uses to generate sales and profits. The amount of sales generated and the
profit earned depend on the effective and efficient management of these asset by firm.
Activity ratios measure the efficiency with which the firm manages and usage its assets. That
is why activity ratios are known as efficiency ratios, because these ratios are converted or
turned over in to sales. Thus the turnover or activity ratios measure the relationship between
sales on one side and various assets on other side.

Higher the turnover ratios, better the profitability and use of capital. Many activity ratios can
be calculated to measure the efficiency of assets utilization. Following are some of the
important activity ratios.

• Total assets turnover ratio

• Capital employed turnover ratio

• Fixed asset turnover ratio

• Current assets turnover ratio

• Working capital turnover ratio

• Stock turnover ratio

• Debtors turnover ratio

• Creditors turnover ratio

4. Coverage Ratio

Coverage ratio measure a company’s ability to make the interest payment and other
obligations associated with its debts. Example include the times intrest earned ratio and debt
service coverage ratio.

5. Market prospect ratio

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These are the most commonly used ratio in fundamental analysis. They include dividend
yield, P/E ratio, earning per share (EPS) and dividend payout ratio. Investors use these
metrics to predict earning and future performance.

Uses of Ratio Analysis

Ratio Analysis can be predict a company’s future performance-for better or worse. Successful
companies generally boast solid ratio in all areas, where in sudden hint of weakness in all
area may spark a significant stock sell-off .

6.TREND ANALYSIS

This method of financial Analysis is similar to the horizontal analysis, in this method also we
compare and review the financial statements of three or more years. Under this, the earliest
year become the base year. The objective is to find any pattern in the financial numbers.
These pattern could be rising (or failing) sales, any seasonal trend, fluctuations in expenses,
and more. An analyst can also use ratio to identify trends (if any) in the financial numbers.
Trend analysis evaluate an organization's financial information over a period of time. Period
may be measured in months, quarters, or years, depending on the circumstances. The goal is
to calculate and analyze the amount change and percent change from one period to the next.

What is Trend analysis?

Trend analysis of financial statements helps information user to discern percentage change
over time in the selected data. For example user can see whether a firm's net profit is
increasing, decreasing, or stable, or whether there are fluctuation over the years.

Explanation

Horizontal analysis of financial statements can easily be expected to include more than a
single change from one year to the next. This is known as trend analysis. In many case, it’ is
important to examine changes over a specific period because this enables the evaluation of

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emerging trend that many influence performance in future years. The five year summary of
selected financial data as found in all annual reports, is useful in this regard. 7

7.CONCLUSION

Financial method analysis help to determine a company’s health and stability, providing an
understanding of how the company conducts it’s business . But it is important to know that
financial statements analysis has its limitations as well. Different accounting method adopted
by different firms changes the visible health and profit levels for either better or worse.
Different analyst may get different result from the same information. Hence we must
conclude that financial statements analysis is only one of the tools although a major one)
while taking an investment decisions.

8.BIBLIOGRAPHY

https:// www.investopedia.com

https://corporatefinacialistitute.com

https://gocarddless.com

https://online.hbs.edu

https://en.m.wikipedia.org

https://www.accountingtools.com

7
Adam Hayes, Understanding Trend Analysis and Trend Trading Strategies, (sept.13, 2023 22:11),
https://www.investopedia.com/terms/t/trendanalysis.asp

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