Analysis of Financial Statements

Financial statements show what a company earned and what it owns and owes, but the raw figures mean little until they are analysed. In this chapter you will learn the meaning, significance, objectives and limitations of the analysis of financial statements, and the main tools used for it: comparative statements, common size statements, ratio analysis and the cash flow statement. You will prepare a comparative Statement of Profit and Loss and Balance Sheet showing absolute and percentage changes over two years, and common size statements in which each item is expressed as a percentage of revenue from operations or of total assets. The chapter then develops accounting ratios in four groups as prescribed by CBSE: liquidity ratios (current ratio and quick ratio), solvency ratios (debt-equity, total assets to debt, proprietary and interest coverage ratios), activity or turnover ratios (inventory, trade receivables, trade payables and working capital turnover) and profitability ratios (gross profit, operating, operating profit, net profit and return on investment). You will interpret each ratio and recognise the limitations of ratio analysis.

Detailed Worksheet: Analysis of Financial Statements Section A - Definitions (10 marks) 1. What is meant by analysis of financial statements? State any two objectives of such analysis. (2 marks) 2. Distinguish between horizontal analysis and vertical analysis, naming the tool used for each. (2 marks) 3. What is a common size statement? On what base are the items of the Statement of Profit and Loss and the Balance Sheet expressed? (2 marks) 4. Define current ratio and quick ratio. Why is inventory excluded from quick assets? (2 marks) 5. State any four limitations of ratio analysis. (2 marks) Section B - Calculations and Applications (15 marks) 6. From the following, calculate the current ratio and the quick ratio: inventories Rs 1,00,000; trade receivables Rs 1,50,000; cash and cash equivalents Rs 1,40,000; prepaid expenses Rs 10,000; trade payables Rs 1,60,000; short-term borrowings Rs 40,000. (3 marks) 7. Revenue from operations is Rs 10,00,000 and cost of revenue from operations is Rs 7,50,000. Opening inventory is Rs 1,40,000 and closing inventory is Rs 1,60,000. Calculate the gross profit ratio and the inventory turnover ratio. (3 marks) 8. Credit revenue from operations is Rs 6,00,000. Trade receivables at the beginning and end of the year are Rs 90,000 and Rs 1,10,000. Calculate the trade receivables turnover ratio and the average collection period (take 365 days in a year). (3 marks) 9. A company has equity share capital of Rs 5,00,000, reserves and surplus of Rs 3,00,000, 10% debentures of Rs 4,00,000 and current liabilities of Rs 2,00,000. Calculate the debt-equity ratio and the proprietary ratio, given total assets of Rs 14,00,000. (3 marks) 10. Revenue from operations increased from Rs 10,00,000 in 2024-25 to Rs 12,50,000 in 2025-26, and cost of materials consumed increased from Rs 6,00,000 to Rs 7,20,000. Prepare these two lines of a comparative Statement of Profit and Loss showing absolute change and percentage change. (3 marks) Section C - Diagrams (10 marks) 11. Draw a chart classifying accounting ratios into liquidity, solvency, activity and profitability ratios, listing at least two ratios under each head with their formulae. (4 marks) 12. Draw a chart showing the tools of financial analysis: comparative statements, common size statements, ratio analysis and cash flow statement, indicating whether each is a horizontal or vertical technique. (3 marks) 13. Draw the format (as labelled column headings in prose form) of a comparative Balance Sheet and a common size Balance Sheet, showing the columns used in each. (3 marks) Section D - Analysis and Higher-order Thinking (15 marks) 14. A company has a current ratio of 2.5:1 and a quick ratio of 1.5:1. Its current liabilities are Rs 2,00,000. Calculate current assets and inventory (assume no prepaid expenses). Then state, with reasons, the effect on the current ratio of (i) payment of Rs 50,000 to a trade payable and (ii) purchase of goods worth Rs 30,000 on credit. (5 marks) 15. Profit before interest and tax is Rs 3,00,000, interest on long-term debt is Rs 50,000, and capital employed is Rs 12,00,000. Calculate the interest coverage ratio and return on investment. Interpret both ratios for a lender and for an equity investor. (5 marks) 16. Two firms in the same industry show the following: Firm X has a gross profit ratio of 30% and a net profit ratio of 5%, while Firm Y has a gross profit ratio of 22% and a net profit ratio of 9%. Analyse what these figures suggest about the cost structure of each firm, and recommend which ratio the management of Firm X should examine next. (5 marks) Instructions: Time allowed 2 hours. Attempt all sections. Show the formula for each ratio before substituting values, and round answers to two decimal places.