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Analysis of Financial Statements – Class 12 Accountancy notes, important questions and MCQs

NCERT Class 12 Accountancy, chapter 8. Notes, key terms, important questions with answers and MCQs.

Chapter overview

Analysis of financial statements is the process of studying the relationships among items in financial statements to judge a company's profitability, liquidity, solvency and efficiency. It uses tools such as comparative statements, common-size statements, ratio analysis and cash flow analysis. The results help investors, lenders, management and others take decisions, though analysis has limitations.

Objectives and significance

To assess the earning capacity (profitability) and the ability to pay short-term and long-term debts (liquidity and solvency).
To judge the efficiency of management in using assets, and to compare performance over time and with other firms.
It is useful for investors, creditors, management, employees and government.

Tools of analysis

Comparative statements show figures for two or more periods side by side with absolute and percentage changes (horizontal analysis).
Common-size statements express each item as a percentage of a common base: revenue from operations for the statement of profit and loss, and total assets or total equity and liabilities for the balance sheet (vertical analysis).
Ratio analysis studies relationships between items; cash flow analysis studies the sources and uses of cash.

Limitations

Analysis is based on historical data and is affected by the limitations of financial statements.
Changes in accounting policies and price levels reduce comparability; qualitative factors are ignored.
Results can be misleading if window dressing has been done or if the analyst is biased.

Key terms

Analysis of financial statements: the systematic study of financial statements to judge profitability and financial position
Comparative statement: a statement showing figures of two or more periods side by side with changes
Common-size statement: a statement in which items are shown as percentages of a common base
Horizontal analysis: comparing financial data over several periods
Vertical analysis: analysing items of one period as percentages of a base figure

Important questions with answers

What is a common-size statement?2 marks

A common-size statement is a statement in which each item is expressed as a percentage of a common base, such as revenue from operations in the statement of profit and loss or total assets in the balance sheet. It helps compare the structure of statements over time or between firms of different sizes.

State the objectives of analysis of financial statements.3 marks

The objectives are to assess the earning capacity or profitability of the firm, to judge its short-term liquidity and long-term solvency, to evaluate the efficiency of management in using resources, to compare performance over time and with other firms, and to help users forecast future performance and take decisions.

Explain the tools of analysis of financial statements and their limitations.5 marks

Several tools are used to analyse financial statements. Comparative statements present figures of two or more periods side by side along with absolute changes and percentage changes; this horizontal analysis reveals trends, such as growth in revenue or expenses. Common-size statements express each item as a percentage of a common base, revenue from operations for the statement of profit and loss and total assets or total equity and liabilities for the balance sheet; this vertical analysis shows the structure and allows comparison between firms of different sizes. Ratio analysis calculates relationships between items, such as the current ratio, debt-equity ratio, inventory turnover ratio and net profit ratio, to judge liquidity, solvency, efficiency and profitability. Cash flow analysis, through a cash flow statement prepared as per AS 3, shows the inflows and outflows of cash from operating, investing and financing activities. Financial analysis has limitations. It is based on historical data and inherits the limitations of financial statements. Changes in accounting policies and price levels reduce comparability. Qualitative factors such as management quality and labour relations are ignored. Window dressing can distort results, and analysis depends on the skill and judgement of the analyst.

Quick revision

Objectives: profitability, liquidity, solvency, efficiency.
Tools: comparative, common-size, ratio, cash flow.
Horizontal vs vertical analysis.
Limitations: historical data, price changes, window dressing.

Exam tips

Remember the common base: revenue from operations for P&L; total assets for the balance sheet.
In comparative statements, show both absolute change and percentage change.

Practice MCQs

Studying financial statements to judge profitability and position is
1. analysis of financial statements
2. auditing
3. book-keeping
4. costing
Show answer
Answer: (a) analysis of financial statements. It uses several tools.
A statement showing figures of two years side by side is a
1. comparative statement
2. common-size statement
3. cash flow statement
4. trial balance
Show answer
Answer: (a) comparative statement. It shows changes.
In a common-size statement of profit and loss, items are expressed as a percentage of
1. revenue from operations
2. total assets
3. net profit
4. share capital
Show answer
Answer: (a) revenue from operations. Revenue is taken as 100.
Comparing data over several years is called
1. horizontal analysis
2. vertical analysis
3. ratio analysis only
4. cost analysis
Show answer
Answer: (a) horizontal analysis. It shows trends.
In a common-size balance sheet, the base is usually
1. revenue
2. cash
3. net profit
4. total assets or total equity and liabilities
Show answer
Answer: (d) total assets or total equity and liabilities. It is taken as 100.
Which tool studies the sources and uses of cash
1. cash flow analysis
2. comparative statement
3. common-size statement
4. trial balance
Show answer
Answer: (a) cash flow analysis. It is based on AS 3.
Revenue rises from ₹10,00,000 to ₹12,00,000. In a comparative statement, the percentage change is
1. 12 per cent
2. 20 per cent
3. 2 per cent
4. 120 per cent
Show answer
Answer: (b) 20 per cent. 2,00,000 ÷ 10,00,000 × 100.
Which is a limitation of financial analysis
1. it shows trends
2. it ignores qualitative factors such as management quality
3. it helps lenders
4. it uses ratios
Show answer
Answer: (b) it ignores qualitative factors such as management quality. Only quantitative data are analysed.

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Written by Kundali IQ from standard, well-established facts to help with revision. This is not an official NCERT publication; always read your textbook too.