NCERT Solutions for Class 12 Accountancy Accountancy Part II Chapter 4: Analysis of Financial Statements

Chapter at a glance

Questions for Practice – Short Answer Questions

Question SA – Q1

List the techniques of Financial Statement Analysis.

Answer

1. Comparative statements
2. Common-size statements
3. Trend analysis
4. Ratio analysis
5. Cash flow analysis

Comparative statements, common-size statements, trend analysis, ratio analysis and cash flow analysis.

Question SA – Q2

Distinguish between Vertical and Horizontal Analysis of financial data.

Answer

Horizontal analysis compares figures over several years (dynamic); vertical analysis relates items of one year to a common base (static).

Question SA – Q3

State the meaning of Analysis and Interpretation.

Answer

Analysis means methodical classification and rearrangement of the data in financial statements into simplified form, and establishing relationships between items (by comparisons, ratios, percentages).

Interpretation means explaining the meaning and significance of the data so simplified, and drawing conclusions about profitability, solvency, efficiency and trends, for decision-making.

Analysis is simplifying and relating the data of financial statements; interpretation is explaining what the analysed data means and drawing conclusions.

Question SA – Q4

State the importance of Financial Analysis?

Answer

1. Judges earning capacity (profitability) of the business.
2. Judges short-term solvency (liquidity) and long-term solvency.
3. Shows trends and helps forecasting and budgeting.
4. Helps inter-firm and intra-firm comparison.
5. Helps assess managerial efficiency.
6. Helps investors, lenders and government in decision-making.

It reveals profitability, liquidity, solvency, trends and managerial efficiency, and helps comparison, forecasting and decision-making.

Question SA – Q5

What are Comparative Financial Statements?

Answer

Comparative financial statements show the figures of the balance sheet and/or statement of profit and loss for two or more periods side by side, along with the absolute change and percentage change in each item. They reveal the direction and extent of changes in the financial position and performance of a business over time.

They present the figures of two or more years side by side, with absolute and percentage changes, to show trends.

Question SA – Q6

What do you mean by Common Size Statements?

Answer

Common-size statements express each item of a financial statement as a percentage of a common base:

• in the Statement of Profit and Loss, the base is revenue from operations (= 100);
• in the Balance Sheet, the base is the total of assets or total of equity and liabilities (= 100).

They make inter-firm and inter-period comparison easier, as absolute figures are converted into proportions.

Statements in which each item is shown as a percentage of a common base – revenue from operations or the balance-sheet total.

Questions for Practice – Long Answer Questions

Question LA – Q1

Describe the different techniques of financial analysis and explain the limitations of financial analysis.

Answer

Techniques

1. Comparative statements – figures of two or more periods compared, with absolute and % changes (horizontal analysis).
2. Common-size statements – items expressed as % of a common base (vertical analysis).
3. Trend analysis – a base year is taken as 100 and later years’ figures are expressed as % of it, to show the trend.
4. Ratio analysis – relationships between items (liquidity, solvency, activity and profitability ratios).
5. Cash flow analysis – inflows and outflows of cash from operating, investing and financing activities.

Limitations

1. Based on historical data – past results may not hold in future.
2. Ignores price-level changes – comparisons over years can mislead.
3. Qualitative aspects (management quality, labour relations) are ignored.
4. Affected by window dressing.
5. Affected by personal bias of the analyst and accounting policies.
6. Different accounting practices make inter-firm comparison difficult.
7. Analysis is a means, not an end – it needs skilled interpretation.

Techniques: comparative and common-size statements, trend, ratio and cash flow analysis. Limitations: historical data, price changes and qualitative factors ignored, window dressing, bias and differing accounting practices.

Question LA – Q2

Explain the usefulness of trend percentages in interpretation of financial performance of a company.

Answer

In trend analysis, one year is taken as the base year (= 100) and figures of other years are expressed as percentages of the base year:

Trend % = (Current year figure ÷ Base year figure) × 100.

Usefulness

1. Shows the direction (upward/downward) of important items such as sales, cost, profit and assets over several years.
2. Easy to understand – one series of percentages replaces many absolute figures.
3. Helps compare related items (e.g. if sales rise 20 % but expenses rise 40 %, profitability is falling).
4. Helps in forecasting and planning.
5. Helps judge managerial efficiency and growth over a long period.
6. Useful for inter-firm comparison when the same base year is used.

(Care: the base year should be a normal year; price-level changes affect trends.)

Trend percentages (base year = 100) show the direction and rate of change of key items over years, allow comparison of related items, and help forecasting and judging growth and efficiency.

Question LA – Q3

What is the importance of comparative statements? Illustrate your answer with particular reference to comparative income statement.

Answer

Importance

1. Shows the changes (absolute and %) in each item between periods.
2. Reveals trends in revenue, expenses and profit.
3. Helps inter-firm and intra-firm comparison.
4. Highlights strengths and weaknesses, e.g. a fall in gross margin.
5. Helps forecasting and planning.

Illustration – Comparative Statement of Profit and Loss

Interpretation: revenue grew by 25 %, but expenses grew faster (32 %), so profit rose by only 8 %. Management should control costs.

Comparative statements show absolute and percentage changes, revealing trends, strengths and weaknesses; e.g. revenue up 25 % but expenses up 32 % means profit grew only 8 %, a sign that costs need control.

Question LA – Q4

What do you understand by analysis and interpretation of financial statements? Discuss its importance.

Answer

Analysis is the systematic classification of data in financial statements and the establishment of relationships among them; interpretation is explaining the meaning of those relationships to draw conclusions. Together they turn raw figures into useful information about profitability, liquidity, solvency and efficiency.

Importance

1. Shareholders/investors – judge earning capacity and safety of investment.
2. Creditors – judge liquidity and ability to pay.
3. Lenders – judge long-term solvency before granting loans.
4. Management – evaluate performance, control costs, plan for the future.
5. Employees – judge stability and bonus prospects.
6. Government – tax and policy decisions.
7. Comparison – inter-period and inter-firm, and forecasting of future trends.

Analysis simplifies and relates the data; interpretation explains it. Together they help shareholders, creditors, lenders, management, employees and government judge profitability, liquidity, solvency and trends.

Question LA – Q5

Explain how common size statements are prepared giving an example.

Answer

Steps

1. Take the common base as 100 – revenue from operations for the Statement of Profit and Loss; total assets (= total equity and liabilities) for the Balance Sheet.
2. Express each item as a percentage of the base: % = (Item ÷ Base) × 100.
3. Show the absolute amounts and percentages side by side, for one or more years or firms.

Example – Common-size Statement of Profit and Loss

Take revenue from operations (or the balance-sheet total) as 100 and express every item as a percentage of it, e.g. cost of revenue 60 %, gross profit 40 %, PAT 21 %.

Questions for Practice – Numerical Questions

Question Num – Q1

Following are the balance sheets of Alpha Ltd., as at March 31, 2016 and 2017. You are required to prepare Comparative Balance Sheet. (2016 / 2017, ₹) Share Capital 2,00,000 / 4,00,000; Reserves and Surplus 1,00,000 / 1,50,000; Long-term Borrowings 2,00,000 / 3,00,000; Short-term borrowings 50,000 / 70,000; Trade Payables 30,000 / 60,000; Other Current Liabilities 20,000 / 10,000; Short-term Provisions 20,000 / 20,000; Total 6,20,000 / 10,20,000. Fixed Assets 2,00,000 / 5,00,000; Non-Current Investments 1,00,000 / 1,25,000; Current Investments 60,000 / 80,000; Inventories 1,35,000 / 1,55,000; Trade Receivables 60,000 / 90,000; Cash and Cash Equivalents 25,000 / 10,000; Short-term Loans and Advances 40,000 / 60,000; Total 6,20,000 / 10,20,000.

Answer

Comparative Balance Sheet of Alpha Ltd. as at March 31, 2016 and 2017

Interpretation: total resources rose by 64.52 %. Fixed assets grew 150 %, financed mainly by long-term funds (share capital doubled; long-term borrowings up 50 %). Cash fell by 60 %, while trade payables doubled; liquidity needs watching.

Total of the balance sheet rose by ₹ 4,00,000 (64.52 %); fixed assets +150 %, share capital +100 %, cash –60 %.

Question Num – Q2

Following are the Balance Sheets of Beta Ltd., as at March 31, 2016 and 2017 (₹): Share Capital 4,00,000 / 3,00,000; Reserves and surplus 1,50,000 / 1,00,000; Long-term IDBI loan 3,00,000 / 1,00,000; Short-term borrowings 70,000 / 50,000; Trade payables 60,000 / 30,000; Other current liabilities 1,10,000 / 1,00,000; Short-term provisions 10,000 / 20,000; Total 11,00,000 / 7,00,000. Fixed Assets 4,00,000 / 2,20,000; Non-current Investments 2,25,000 / 1,00,000; Current Investments 80,000 / 60,000; Inventories 1,05,000 / 90,000; Trade Receivables 90,000 / 60,000; Cash and Cash Equivalents 1,00,000 / 85,000; Short-term loans and Advances 1,00,000 / 85,000; Total 11,00,000 / 7,00,000. Prepare comparative Balance Sheet.

Answer

(The book prints the 2016 total of equity and liabilities as “1,10,000”; the items add up to ₹ 11,00,000.)

Comparative Balance Sheet of Beta Ltd. as at March 31, 2016 and 2017

Interpretation: the business has contracted by 36.36 %. The long-term IDBI loan fell by 66.67 % and share capital by 25 %. Fixed assets fell by 45 %, and non-current investments by 55.56 %.

Total of the balance sheet fell by ₹ 4,00,000 (36.36 %); long-term borrowings –66.67 %, fixed assets –45 %, short-term provisions +100 %.

Question Num – Q3

Prepare Comparative Statement of profit and loss from the following information (2015-16 / 2016-17, ₹): Freight Outward 20,000 / 10,000; Wages (office) 10,000 / 5,000; Manufacturing Expenses 50,000 / 20,000; Stock adjustment (60,000) / 30,000; Cash purchases 80,000 / 60,000; Credit purchases 60,000 / 20,000; Return inward 8,000 / 4,000; Gross profit (30,000) / 90,000; Carriage outward 20,000 / 10,000; Machinery 3,00,000 / 2,00,000; 10% depreciation on machinery 10,000 / 5,000; Interest on short-term loans 20,000 / 20,000; 10% debentures 20,000 / 10,000; Profit on sale of furniture 20,000 / 10,000; Loss on sale of office car 90,000 / 60,000; Tax rate 40% / 50%.

Answer

Workings

• Cost of revenue = purchases + manufacturing expenses + stock adjustment.
  • 2015-16: 1,40,000 + 50,000 – 60,000 = ₹ 1,30,000.
  • 2016-17: 80,000 + 20,000 + 30,000 = ₹ 1,30,000.
• Revenue from operations (net of returns) = cost of revenue + gross profit.
  • 2015-16: 1,30,000 – 30,000 = ₹ 1,00,000.
  • 2016-17: 1,30,000 + 90,000 = ₹ 2,20,000.
• Finance costs = interest on short-term loans + 10 % interest on debentures.
  • 2015-16: 20,000 + 2,000 = ₹ 22,000.
  • 2016-17: 20,000 + 1,000 = ₹ 21,000.
• Other expenses = manufacturing expenses + freight outward + carriage outward + loss on sale of office car.
  • 2015-16: 50,000 + 20,000 + 20,000 + 90,000 = ₹ 1,80,000.
  • 2016-17: 20,000 + 10,000 + 10,000 + 60,000 = ₹ 1,00,000.
• Machinery is a balance-sheet item and is not shown here. There is a loss in both years, so no tax is payable.

Comparative Statement of Profit and Loss for the years ended March 31, 2016 and 2017

Revenue from operations rose from ₹ 1,00,000 to ₹ 2,20,000 (+120 %); loss before tax fell from ₹ 1,82,000 to ₹ 11,000 (an improvement of ₹ 1,71,000); no tax in either year.

Question Num – Q4

Prepare Comparative Statement of Profit and Loss from the following information (2015-16 / 2016-17): Manufacturing expenses ₹ 35,000 / ₹ 80,000; Opening stock ₹ 30,000 / 60% of closing stock; Sales ₹ 9,60,000 / ₹ 4,50,000; Returns outward ₹ 4,000 (out of credit purchase) / ₹ 6,000 (out of cash purchase); Closing stock 150% of opening stock / ₹ 1,00,000; Credit purchases ₹ 1,50,000 / 150% of cash purchase; Cash purchases 80% of credit purchases / ₹ 40,000; Carriage outward ₹ 10,000 / ₹ 30,000; Building ₹ 1,00,000 / ₹ 2,00,000; Depreciation on building 20% / 10%; Interest on bank overdraft ₹ 5,000 / –; 10% debentures ₹ 2,00,000 / ₹ 20,00,000; Profit on sale of copyright ₹ 10,000 / ₹ 20,000; Loss on sale of personal car ₹ 10,000 / ₹ 20,000; Other operating expenses ₹ 20,000 / ₹ 10,000; Tax rate 50% / 40%.

Answer

Workings

2015-16

• Closing stock = 150 % × 30,000 = ₹ 45,000.
  • Cash purchases = 80 % × 1,50,000 = ₹ 1,20,000.
  • Net purchases = 1,50,000 + 1,20,000 – 4,000 = ₹ 2,66,000.

2016-17

• Opening stock = 60 % × 1,00,000 = ₹ 60,000.
  • Credit purchases = 150 % × 40,000 = ₹ 60,000.
  • Net purchases = 40,000 + 60,000 – 6,000 = ₹ 94,000.
• Finance costs (OD interest + 10 % on debentures)
  • 2015-16: 5,000 + 20,000 = ₹ 25,000.
  • 2016-17: 0 + 2,00,000 = ₹ 2,00,000.

Depreciation

• 2015-16: 20 % × 1,00,000 = ₹ 20,000.
  • 2016-17: 10 % × 2,00,000 = ₹ 20,000.
• Other expenses (manufacturing + carriage outward + other operating)
  • 2015-16: 35,000 + 10,000 + 20,000 = ₹ 65,000.
  • 2016-17: 80,000 + 30,000 + 10,000 = ₹ 1,20,000.
• The loss on sale of a personal car is not a business expense and is ignored.

Comparative Statement of Profit and Loss

Profit after tax fell from ₹ 3,04,500 to ₹ 45,600 (–85.02 %), mainly due to lower sales (–53.13 %) and a big rise in finance costs (₹ 25,000 → ₹ 2,00,000).

Question Num – Q5

Prepare a Common size statement of profit and loss of Shefali Ltd. with the help of following information (2015-16 / 2016-17): Revenue from operations ₹ 6,00,000 / ₹ 8,00,000; Indirect expenses 25% of gross profit / 25% of gross profit; Cost of revenue from operations ₹ 4,28,000 / ₹ 7,28,000; Other incomes ₹ 10,000 / ₹ 12,000; Income tax 30% / 30%.

Answer

(2016-17 revenue printed as “8,00,00” is taken as ₹ 8,00,000.)

Common-size Statement of Profit and Loss of Shefali Ltd. (% of revenue from operations)

Interpretation: the cost of revenue rose from 71.33 % to 91 % of sales, so the gross margin fell from 28.67 % to 9 %, and net profit from 16.22 % to 5.78 % of sales.

PAT as % of revenue fell from 16.22 % (₹ 97,300) to 5.78 % (₹ 46,200) because cost of revenue rose from 71.33 % to 91 %.

Question Num – Q6

Prepare a Common Size balance sheet from the following balance sheet of Aditya Ltd., and Anjali Ltd.: Equity share capital 6,00,000 / 8,00,000; Reserves and surplus 3,00,000 / 2,50,000; Current liabilities 1,00,000 / 1,50,000; Total 10,00,000 / 12,00,000. Fixed assets 4,00,000 / 7,00,000; Current assets 6,00,000 / 5,00,000; Total 10,00,000 / 12,00,000.

Answer

Common-size Balance Sheet of Aditya Ltd. and Anjali Ltd.

Interpretation: Aditya Ltd. keeps 60 % of its funds in current assets (better liquidity), while Anjali Ltd. has 58.33 % in fixed assets. Both are financed mainly by shareholders’ funds (90 % and 87.5 %).

Aditya: share capital 60 %, reserves 30 %, current liabilities 10 %; fixed assets 40 %, current assets 60 %. Anjali: 66.67 %, 20.83 %, 12.50 %; fixed assets 58.33 %, current assets 41.67 %.

Topic checklist

• ☒ Meaning, objectives, importance and limitations of analysis (SA 1–4; LA 1, 4)
• ☒ Horizontal vs vertical analysis; trend analysis (SA 2; LA 2)
• ☒ Comparative balance sheet and statement of profit and loss (Num 1–4; LA 3)
• ☒ Common-size statements (Num 5, 6; LA 5)

Total questions answered: 17 of 17