What are Financial Statements?
Financial statements are used by investors and business analysts to evaluate the earning potential and growth of a company. This consists of three major components of a business. They are the Profit and Loss A/c, Income and Expenditure A/c, and Balance Sheet. These three reports together are analyzed to find out the overall financial health of a business.
The basic analysis of financial statements depends on the information extracted from the financial statements to calculate other ratios.
Financial Ratios Analysis
The fundamental financial ratios required for the analysis of financial statements are listed below:
1. Working Capital Ratio – This is an important measure of financial health that reveals the company’s capacity to pay its liabilities with its current assets. The calculation of this ratio is made by dividing current assets by current liabilities.
2. Quick Ratio – This shows how far current liabilities could be covered by cash and by materials with cash value.
3. Earnings per Share (EPS) – This measures the net income earned from every share of the company’s common stock.
4. Price-Earnings (P/E) Ratio – This shows the investors’ assessments of future earnings. This is obtained by dividing the share price of the company’s stock by EPS.
5. Debt-Equity Ratio - This has to be analyzed with respect to industry norms and company-specific requirements
6. Return on Equity (ROE) – This has to be calculated by subtracting preferred dividends from the company’s net earnings and divide by common equity dollars in the company.
When these ratios are properly applied, using any one of them can help improve the company’s investing performance. The financial ratios analysis helps to pick stocks for investment portfolios.
The Objective of Financial Statement Analysis
The main objective is to give a clear picture of the financial position, performance, and further changes that are useful in making economic decisions. The statements should be clear, relevant, reliable, good and comparable
Financial Ratio Analysis and Interpretation
Analysing and interpreting financial ratios is rather logical while we don’t need to look at the numbers. This analysis is performed by comparing items in the financial statements. And then the interpretation is done with the result of the analyses rather than depending on the items separately.
Financial ratios of business are classified into ratios that measure the profitability, liquidity, management efficiency, leverage, and valuation & growth.
Analysis and interpretation of financial statements can also be defined as an experiment to reveal the significance of the financial statement so that the prospects for earnings, ability to pay liabilities, and profitability of the business in the future.
Financial Reporting and Analysis of Financial Statements
Financial Analysis and reporting is a major part of financial analysis carried out by various business enterprises in India and across the world. It reveals the financial health of any business and helps them to strengthen their financial resources and management of generated funds effectively.
There are so many techniques that are commonly used for financial statement analysis namely Vertical, Horizontal, Leverage, Growth, Profitability, Liquidity, Efficiency, Cash Flow, Rates of Return, Valuation, Variance, and Scenario & Sensitivity
But the three major techniques used are horizontal analysis, vertical analysis, and ratio analysis.
Horizontal Balance Sheet
A horizontal balance sheet shows assets on the right column, and the liabilities are shown on the left. The assets of a company include both tangible and intangible or either of them. The assets that are physically seen are referred to as tangible assets. The horizontal analysis of financial statements is represented in the following figure:
[Image will be Uploaded Soon]
Methods of Financial Statement Analysis
The various techniques of financial statement analysis are listed below:
Comparative Statement or Comparative Financial and Operating Statements.
Common Size Statements.
Trend Ratios or Trend Analysis.
Average Analysis.
Statement of Changes in Working Capital.
Fund Flow Analysis.
Cash Flow Analysis.
Ratio Analysis.
Cost Volume Profit Analysis
Financial Statement Analysis Project
Project on financial statement analysis ratios is prepared by students to improve their technical, analytical, and communication skills to forecast the economic decisions and discuss the company’s ability to perform and be successful.
FAQs on Financial Statement Analysis Simplified
1. What is financial statement analysis in simple terms?
Financial statement analysis is the process of examining a company's key financial documents, such as the Balance Sheet and Statement of Profit and Loss, to understand its financial health and performance. Think of it as a 'financial check-up' for a business. It helps stakeholders like investors and managers make informed decisions by evaluating the company's profitability, solvency, and operational efficiency.
2. What are the main objectives of analysing a company's financial statements?
The primary objectives of financial statement analysis are to:
Assess Profitability: To measure the earning capacity of the business and understand if profits are increasing or decreasing.
Evaluate Solvency: To check the company's ability to meet its long-term debts and financial obligations.
Judge Liquidity: To determine if the company has enough cash or equivalent assets to pay its short-term debts.
Analyse Operational Efficiency: To see how effectively the company is using its assets and resources to generate sales and profits.
Facilitate Decision-Making: To provide useful information for management, investors, and creditors to make sound economic decisions.
3. What are the key tools for financial statement analysis as per the CBSE Class 12 curriculum for the 2025-26 session?
As per the CBSE 2025-26 syllabus, the main tools for analysing financial statements are:
Comparative Statements: These statements compare financial data from two or more accounting periods to show trends.
Common-Size Statements: These statements convert all financial figures to a percentage of a common base, such as Total Assets or Revenue from Operations.
Accounting Ratios: This involves calculating various ratios (e.g., Liquidity, Solvency, Activity, Profitability) to evaluate different aspects of a company's performance.
Cash Flow Statement: This statement shows the inflow and outflow of cash from operating, investing, and financing activities over a period.
4. What is the difference between horizontal (comparative) and vertical (common-size) analysis?
The key difference lies in the direction of comparison. Horizontal analysis, used in Comparative Statements, compares financial data across multiple time periods (e.g., comparing 2024 sales to 2025 sales) to identify trends. In contrast, vertical analysis, used in Common-Size Statements, analyses items within a single accounting period by expressing each item as a percentage of a base figure (e.g., showing advertising expense as a percentage of total revenue for 2025). Horizontal analysis looks at changes over time, while vertical analysis looks at proportions at one point in time.
5. How is a Comparative Statement prepared and what does it reveal about a business?
A Comparative Statement is prepared by placing the financial data of two or more consecutive years side-by-side. The key columns are: (1) figures for the previous year, (2) figures for the current year, (3) the absolute change (current year - previous year), and (4) the percentage change. This analysis is crucial as it reveals the trend and direction of a company's performance and financial position, highlighting significant increases or decreases in items like revenue, expenses, and assets.
6. What is a Common-Size Statement and what is its main advantage in comparing different companies?
A Common-Size Statement presents all items as a percentage of a common base. For the Balance Sheet, the base is Total Assets, and for the Statement of Profit and Loss, the base is Revenue from Operations. Its primary advantage is that it allows for the comparison of companies of different sizes. By converting absolute figures into percentages, it becomes easy to compare the financial structure and performance of a small company with that of a large one in the same industry.
7. Why is financial statement analysis important for stakeholders other than the company's management?
Financial statement analysis is vital for various external stakeholders:
Investors: They use it to assess the company's profitability and financial soundness before deciding to buy, hold, or sell its shares.
Creditors and Lenders: Banks and financial institutions analyse statements to evaluate a company's ability to repay loans (creditworthiness) before extending credit.
Government and Tax Authorities: They use it to assess the correct tax liability and ensure compliance with regulations.
Employees: They may be interested in the company's stability and profitability for job security and future prospects like bonuses and salary increments.
8. What are some common limitations of financial statement analysis that can affect its conclusions?
While useful, financial statement analysis has several limitations:
Based on Historical Data: It analyses past performance, which is not a guaranteed predictor of future results.
Ignores Qualitative Factors: It does not consider non-monetary aspects like management quality, employee morale, or brand reputation.
Affected by 'Window Dressing': Companies can manipulate financial data to present a more favourable picture than is actually true.
Ignores Price Level Changes: Financial statements do not account for the effects of inflation, which can distort financial results over time.
