Analysis of Financial Statements

Objectives, tools and limitations of analysis, comparative statements with absolute and percentage changes, common-size statements and trend percentages.

Key ideas

Analysis judges earning capacity, short-term and long-term solvency, and compares a firm with others and with its own past years.
Short-term creditors look at liquidity, lenders at long-term solvency and interest cover, shareholders at profitability, management at efficiency.
The tools are comparative statements, common-size statements, ratio analysis, cash flow analysis and trend analysis.
A comparative statement puts two years side by side with the absolute and percentage change of each item (horizontal analysis).
A common-size statement shows each item as a percentage of one base: revenue from operations, or the balance sheet total (vertical analysis).
Trend percentages show each year’s figure as a percentage of the base year, taken as 100.
Analysis ignores price-level changes and qualitative factors, can be distorted by window dressing and depends on the methods chosen.

Remember

Absolute change	this year − last year
Percentage change	absolute change ÷ last year × 100
Common-size, profit and loss	item ÷ revenue from operations × 100
Common-size, balance sheet	item ÷ balance sheet total × 100
Trend percentage	year’s figure ÷ base year’s figure × 100
Last year from this year	this year ÷ (1 + percentage change ÷ 100)

Watch out

Dividing the change by this year’s figure instead of last year’s.
Showing a fall as a positive percentage change.
Using a different base for different items in a common-size statement.

Worked example

Sunrise Ltd has revenue from operations of ₹3,80,000, cost of materials consumed of ₹1,48,200 and employee benefits expense of ₹38,000. Find each expense as a percentage of revenue from operations: (a) materials (b) employee benefits.

Working: (a) ₹1,48,200 ÷ ₹3,80,000 × 100 (b) ₹38,000 ÷ ₹3,80,000 × 100

Answer: (a) 39%; (b) 10%