NCERT Solutions Class 12 Accountancy Chapter 4 Analysis of Financial Statements

TEST YOUR UNDERSTANDING I

Question 1. Analysis simply means - - - data.
Answer: Simplification.
In simple words: Analysis means making complex financial details simpler and easier to understand.
Exam Tip: Remember that "analysis" is the act of breaking down or simplifying, while "interpretation" is explaining those simplified figures.

Question 2. Interpretation means - - - data.
Answer: Explaining.
In simple words: Interpretation involves explaining the meaning of the simplified financial details.
Exam Tip: Always associate interpretation with "explaining" or "giving meaning" to financial data in your exams.

Question 3. Comparative analysis is also known as - - - Analysis.
Answer: Horizontal.
In simple words: Comparative analysis is called horizontal because it looks at the data side-by-side across different years.
Exam Tip: Comparative or horizontal analysis evaluates data over multiple years to find trends and changes.

Question 4. Common size analysis is also known as - - - Analysis.
Answer: Vertical.
In simple words: Common-size analysis is called vertical because it compares different numbers within a single year to one main baseline figure.
Exam Tip: Remember that vertical analysis focuses on a single financial period by converting every item to a percentage of a common base.

Question 5. The analysis of actual movement of money inflow and outflow in an organisation is called - - - analysis.
Answer: cash flow.
In simple words: This analysis tracks the physical movement of cash into and out of the company.
Exam Tip: Cash flow analysis focuses specifically on actual cash movements rather than accounting profits based on accruals.

DO IT YOURSELF I

Question. From the following balance sheet and income statement of Day Dreaming Co. Ltd., for the year ending 2002 and 2003, prepare the comparative statements.

Income Statement

Balance Sheet

Answer: The comparative financial statements are prepared below:

Comparative Income Statement of Day Dreaming Company Limited for the year ended 2005 and 2006

Working Notes:
Absolute change = Current year - Previous year
Change in % = \( \frac{\text{Absolute change}}{\text{Previous year}} \times 100 \)

Comparative Balance Sheet of Day Dreaming Company Limited as on year ended 2005 and 2006

In simple words: These tables show how much each revenue, expense, asset, and liability changed between the two years, both in absolute cash terms and as a percentage. This lets you see if the business grew or shrank.
Exam Tip: Always make sure that percentage changes are computed by dividing the absolute change by the previous year's figure, not the current year's figure.

DO IT YOURSELF II

Question. The following are the Balance Sheets of Harsha Ltd. as on March 31, 2006 and March 31, 2007:

Prepare common size Balance Sheet and interpret the same.

Answer: The Common Size Balance Sheet of Harsha Ltd. is presented below:

Common Size Balance Sheet as on March 31, 2005 and 2006

In simple words: This statement converts every balance sheet line item into a percentage of total assets or total liabilities. This helps you easily compare how different parts of the business's finances change in proportion over time.
Exam Tip: In a common-size Balance Sheet, total assets and total liabilities are always taken as 100%, and each individual item is calculated as a percentage of that total.

TEST YOUR UNDERSTANDING - II

Question 1. The financial statements of a business enterprise include:
(a) Balance sheet
(b) Profit and loss account
(c) Cash flow statement
(d) All of the options
Answer: (d) All of the options
In simple words: A business prepares a full set of financial statements that contains the balance sheet, profit and loss statement, and cash flow statement.
Exam Tip: If asked about the components of financial statements, always remember they comprise the income statement, position statement, and cash flow statement together.

Question 2. The most commonly used tools for financial analysis are:
(a) Horizontal analysis
(b) Vertical analysis
(c) Ratio analysis
(d) All of the options
Answer: (d) All of the options
In simple words: Financial analysts commonly use vertical, horizontal, and ratio analyses to review a company's performance.
Exam Tip: Ensure you are familiar with all three main tools as they form the core syllabus for financial statement analysis.

Question 3. An Annual Report is issued by a company to its:
(a) Directors
(b) Auditors
(c) Shareholders
(d) Management
Answer: (c) Shareholders
In simple words: A company prepares and sends its annual report directly to its shareholders to keep them updated.
Exam Tip: Shareholders are the actual owners of a company, which is why the annual report is primarily addressed to them.

Question 4. Balance Sheet provides information about financial position of the enterprise:
(a) At a point in time
(b) Over a period of time
(c) For a period of time
(d) None of the options
Answer: (a) At a Point of time
In simple words: A balance sheet is like a quick photo that displays the company's financial status on one specific day.
Exam Tip: Always look out for the distinction between "at a point in time" (Balance Sheet) and "for a period of time" (Income Statement).

Question 5. Comparative statement are also known as:
(a) Dynamic analysis
(b) Horizontal analysis
(c) Vertical analysis
(d) External analysis
Answer: (b) Horizontal analysis
In simple words: Comparative statements look at data side-by-side across multiple years, which is called horizontal analysis.
Exam Tip: Keep in mind that comparative statements run horizontally across columns representing consecutive fiscal years.

DO IT YOURSELF III

Question 1. The following data is available from the P&L Account of Deepak Limited:

Calculate the Trend Percentages (Base year 2003 = 100).

Answer: The computed Trend Percentages, using 2003 as the baseline year, are detailed below:

Trend Percentage (Base year 2003 = 100)

In simple words: Trend percentages show how each financial item grows or shrinks over several years compared to the first year, which is set at 100%.
Exam Tip: To calculate trend percentages, divide each year's figure by the base year's figure and multiply by 100.

TEST YOUR UNDERSTANDING III

Question. State whether each of the following is true or false:
(a) The financial statements of a business enterprise include funds flow statement.
(b) Comparative statements are the form of horizontal analysis.
(c) Common size statements and financial ratios are the two tools employed in vertical analysis.
(d) Ratio analysis establishes relationship between two financial statements.
(e) Ratio analysis is a tool for analysing the financial statements of any enterprise.
(f) Financial analysis is used only by the creditors.
(g) Profit and loss account shows the operating performance of an enterprise for a period of time.
(h) Financial analysis helps an analyst to arrive at a decision.
(i) Cash flow statement is a tool of financial statement analysis.
(j) In a common size statement each item is expressed as a percentage of some common base.

Answer:
(a) False - A funds flow statement is helpful but is not a standard requirement within the core financial statements of an enterprise.
(b) True - Comparing statements side-by-side over different years represents horizontal analysis.
(c) True - These methods analyze relationships among different items within the same reporting period.
(d) False - Ratio analysis develops mathematical links between various items within the same financial statement, not across two completely distinct sets.
(e) True - It acts as an invaluable system for understanding and diagnosing financial details.
(f) False - Shareholders, company managers, and lenders also rely on financial analysis.
(g) True - This statement tracks revenues and expenses to evaluate operating performance over a specific period.
(h) True - It prepares critical details that enable investors and managers to make sound choices.
(i) True - Analyzing cash flows is one of the main techniques used to inspect financial sheets.
(j) True - In common-size statements, every item is converted to a percentage of a chosen base figure.
In simple words: These statements test your basic understanding of financial tools. Horizontal analysis compares different years, while vertical analysis evaluates ratios within a single year.
Exam Tip: Be ready for True/False questions by memorizing the core purposes of horizontal, vertical, and cash flow analysis tools.

SHORT ANSWER TYPE QUESTIONS

Question 1. List the techniques of Financial Statement Analysis.
Answer: The core techniques utilized to analyze financial statements include:
(i) Ratio Analysis
(ii) Cash Flow Statement
(iii) Fund Flow Statement
(iv) Comparative Financial Statements
(v) Common Size Financial Statements
(vi) Trend Analysis
In simple words: These are different methods and tools used to study financial reports and check if a company is performing well.
Exam Tip: Memorize this list of six techniques as it is a common question in both theoretical and practical exams.

Question 2. Distinguish between Horizontal Analysis and Vertical Analysis.
Answer: The distinctions between Horizontal and Vertical Analysis are outlined below:

In simple words: Horizontal analysis compares changes over multiple years to find trends, while vertical analysis looks at how different parts of one year's statements relate to a single base.
Exam Tip: Clearly state the basis of difference (such as Meaning, Expression, Benefits, and Purpose) to score full marks in comparative questions.

Question 3. Explain the meaning of Analysis and Interpretation.
Answer: Analysis and interpretation denote a structured, critical review of financial reports. This process clarifies the underlying connections between various values in these reports and reorganizes the figures clearly. The core objective is to make complex records simple and direct to understand. This helps internal and external stakeholders assess business performance over time, formulate future guidelines, design strategies, and make sound decisions.
In simple words: Analysis means breaking down complex financial data into simpler parts, while interpretation is explaining what those parts actually tell us about the business.
Exam Tip: Mention both parts in your answer - simplification (analysis) and explanation of meaning (interpretation) - to show a complete understanding.

Question 4. Bring out the importance of Financial Analysis.
Answer: Financial analysis is very important for many stakeholders who rely on accounting data. Balance sheets, income statements, and other financial records reveal details on earnings, expenditures, and net profits, but they are of limited value until they are systematically studied. Tools like ratios and cash flow statements tailor this raw data to fit the varied needs of users.
The primary reasons supporting the importance of financial analysis are:
(i) It helps check how much profit a company can earn and its financial health.
(ii) It assists in verifying if the business can pay its long-term debts.
(iii) It allows a firm's financial standing to be compared with competitor companies.
(iv) It guides managers in organizing, controlling, and making key business decisions.
In simple words: Financial analysis turns raw numbers into useful insights, helping managers, investors, and lenders see if a business is secure and making a profit.
Exam Tip: Be prepared to list at least four key parties (like management, shareholders, creditors, and competitors) and how they benefit from financial analysis.

Question 5. What are Comparative Financial Statements?
Answer: Comparative financial statements are reports that compare a business's financial data across different years or with other firms. They display actual values, absolute changes, and percentage changes side-by-side. This arrangement lets users evaluate progress and development over time. To ensure these comparisons remain meaningful, the underlying accounting rules and practices must stay consistent throughout the evaluated periods.
The two standard comparative statements prepared are:
(i) Comparative Balance Sheet
(ii) Comparative Income Statement
In simple words: These statements put financial figures from different years side-by-side so you can easily spot where the business is growing or declining.
Exam Tip: Highlight that these statements display both absolute changes and percentage changes, as this is their defining feature.

Question 6. What do you mean by Common Size Statements?
Answer: Common-size statements express the relationship between different financial items and a shared baseline value in percentage terms. For example, in an income statement, individual details like cost of sales and operational expenses are shown as a percentage of Net Sales.
In a balance sheet, asset and liability entries are presented as a percentage of total assets or total liabilities. This enables straightforward comparison with previous years or other businesses in the same sector. This form of evaluation is known as vertical analysis.
The two primary types of common-size statements are:
(i) Common-Size Balance Sheet
(ii) Common-Size Income Statement
In simple words: These statements turn all financial numbers into percentages of one big total, making it simple to compare companies of different sizes.
Exam Tip: Remember that the common base for an income statement is Net Sales, whereas the base for a balance sheet is Total Assets or Liabilities.

LONG ANSWER TYPE QUESTIONS

Question 1. Describe the different techniques of financial analysis and explain the limitations of financial analysis.
Answer: The primary techniques used in financial analysis are:
(i) Comparative Statements: These show profitability and financial positions over multiple periods. They list items side-by-side to highlight the direction of operations, provided accounting principles are kept uniform. This is also called horizontal analysis.
(ii) Common-Size Statements: These display the proportion of individual items against a shared baseline as a percentage. This makes it easy to compare companies of different sizes within the same industry, and is referred to as vertical analysis.
(iii) Trend Analysis: This calculates the percentage changes in financial items over several years against a base year. It helps identify the long-term direction of the business.
(iv) Ratio Analysis: This highlights the mathematical links between various items in the balance sheet and profit and loss account, measuring their relative importance.
(v) Cash Flow Analysis: This tracks the movement of actual cash into and out of the firm, showing cash inflows and cash outflows.

The limitations of financial analysis are:
(i) Ignores price level changes: Since financial statements use historical costs, they fail to adjust for inflation, which can distort long-term comparisons.
(ii) Can provide misleading information: They do not easily show changes in internal accounting practices, which can lead to incorrect conclusions.
(iii) Fails to provide a final picture: These analysis reports are interim and do not show the complete or final state of a firm's health.
(iv) Considers only monetary aspects: Non-monetary factors like managerial skill, employee efficiency, or brand reputation are ignored because they cannot be measured in cash.
(v) Based on conventions: Because accounting relies on certain assumptions and conventions, the resulting analysis might not always be fully reliable.
(vi) Subject to personal bias: The choices made by accountants regarding depreciation methods or inventory valuation can introduce bias and alter the results.
(vii) Hard to compare: Variations in accounting methods between different firms can make comparative analysis difficult.
In simple words: Financial analysis techniques help us study business reports, but they have limits because they ignore inflation, focus only on money, and can be affected by personal bias.
Exam Tip: Make sure to structure your answer with clear headings for both "Techniques" and "Limitations" to present a well-organized response.

Question 2. Explain the usefulness of trend percentages in interpretation of financial performance of a company.
Answer: Trend analysis converts financial figures into percentage values over a series of years. This helps users spot patterns, assess performance, and predict future business movements.
Key benefits of trend analysis include:
(i) Assists in forecasting: The trend percentages help users project future directions of the business.
(ii) Simplifies data in percentage terms: Expressing figures as percentages makes analysis quick, simple, and straightforward.
(iii) Easy to use: Since it relies on simple percentage movements, it does not require highly advanced accounting knowledge to understand.
(iv) Gives a broader perspective: It presents a long-term view of the business, often covering 5 to 10 years, to show overall viability and operational efficiency.
In simple words: Trend percentages show you how different parts of a business grow or shrink over many years compared to a base year, helping you predict the future.
Exam Tip: Mention that trend analysis is highly user-friendly and presents a broader picture over a long span of time (like 5 to 10 years).

Question 3. What is the importance of comparative statements? Illustrate your answer with particular reference to comparative income statement.
Answer: Comparative statements are highly useful tools in financial analysis. Their key benefits are:
(i) Simplifies presentation: Presenting multiple years of data side-by-side makes the information clear and easy to compare.
(ii) Helps draw conclusions: The side-by-side layout allows analysts to quickly spot changes and make decisions without confusion.
(iii) Assists in forecasting: Managers can study past trends to make accurate predictions and plan future policies.
(iv) Detects issues: Comparing actual performance against planned targets helps identify problem areas so corrective steps can be taken.

For example, a comparative income statement highlights changes in sales, expenses, and net profit over time. If sales grew by 15% but operating expenses rose by 30%, this statement quickly alerts management to a decline in profit efficiency.
In simple words: Comparative statements let you look at financial figures from different years side-by-side, helping you see where the business is improving or facing issues.
Exam Tip: Use a simple hypothetical illustration (like comparing sales growth versus expense growth) to explain the comparative income statement clearly.

Question 4. What do you understand by analysis and interpretation of financial statements? Discuss their importance.
Answer: Analyzing and interpreting financial statements means conducting a methodical study of a company's financial records to understand its performance and position. It translates complex numbers into actionable information.
Its main importance lies in:
(i) Measuring profit-earning capacity and overall financial viability.
(ii) Assessing whether the company can pay back its long-term debts.
(iii) Comparing the firm's efficiency with its industry peers.
(iv) Supporting management in planning, decision-making, and controlling operations.
In simple words: Analysis simplifies the financial numbers, while interpretation explains what those numbers mean, helping managers and investors make smart decisions.
Exam Tip: Emphasize that raw numbers are not useful on their own, and financial analysis is what makes them meaningful for decision-making.

Question 5. Explain how common size statements are prepared giving an example.
Answer: Common-size statements are prepared by converting each individual line item of a financial report into a percentage of a chosen common baseline figure.
They are usually structured using three main columns:
(a) Particulars: Lists the financial items under their respective heads.
(b) Amount columns: Displays the absolute monetary figures for each year.
(c) Percentage columns: Shows the proportion of each item relative to the base value.

There are two standard methods of presentation:
- Method 1: Placing the percentage column directly next to its corresponding yearly amount column.
- Method 2: Grouping all yearly amount columns first, followed by all percentage columns.

Example: Let us prepare a Common Size Balance Sheet for Indo Press Limited using the following data:

Balance Sheet of Indo Press Limited

Alfa Limited - Common Size Balance Sheet for the year 2010 and 2011

In simple words: This example shows how to convert actual balance sheet figures into percentages of the grand total, making it much easier to track shifts in the business structure.
Exam Tip: When preparing common size statements, remember to clearly state the baseline (like total assets/liabilities or net sales) that you used as 100%.

Question 1. From the following information of Narsimham Company Ltd., prepare a Comparative Income Statement for the years 2004-2005

Answer:
Comparative Income Statement

Interpretation
(i) The firm's net earnings exhibited an upward growth.
(ii) In parallel, management succeeded in cost-containment measures to enhance operating margins.
(iii) Over the course of the year, the enterprise's general profitability showed notable progress.

Working Note:
\[ \text{Absolute Change} = \text{Current Year Value} - \text{Previous Year Value} \]
\[ \text{Percentage Change} = \left( \frac{\text{Absolute Change}}{\text{Previous Year Value}} \right) \times 100 \]
In simple words: This comparative statement tracks changes in revenues and expenses between two years. The business did well because its net profit and overall sales went up significantly.
Exam Tip: In comparative statements, always ensure brackets indicate negative changes. Check percentage calculations to two decimal places to earn full marks.

Question 2. The following are the Balance Sheets of Mohan Ltd., at the end of 2004 and 2005. Prepare a Comparative Balance Sheet and study the financial position of the company.

Answer:
Comparative Balance Sheet of Mohan Limited

Comments:
(i) The drop in short-term obligations exceeded the decline in liquid assets, demonstrating a healthier current liquidity ratio.
(ii) A reduction in available cash balances might lead to potential delays in settling immediate dues.
(iii) The simultaneous expansion of long-term assets and equity indicates that acquisitions were funded through long-term capital channels.
(iv) Growth in retained earnings and reserves serves as a positive sign of financial strength.

Working Note:
\[ \text{Absolute Change} = \text{Current Year Value} - \text{Previous Year Value} \]
\[ \text{Percentage Change} = \left( \frac{\text{Absolute Change}}{\text{Previous Year Value}} \right) \times 100 \]
In simple words: The balance sheet shows the business purchased fixed assets like machinery using stable, long-term financing instead of short-term loans. Although its cash has dropped, its overall ability to handle short-term debts improved.
Exam Tip: Be sure to group assets and liabilities into 'Current' and 'Non-current' sub-categories clearly. Check that total assets exactly match total liabilities + shareholder equity.

Question 3. The following are the balance sheets of Devi Company Limited at the end of 2011 and 2012. Prepare a comparative Balance Sheet and study the financial position of the concern.

Answer:
Comparative Balance Sheet of Devi Company Limited

Comments:
(i) Since short-term resources and obligations grew at nearly identical rates, the liquidity ratio remains largely unchanged from last year.
(ii) An increase in long-term investments alongside equity expansion shows that non-current assets were acquired using long-term financial channels.
(iii) On the whole, the enterprise maintains a steady and sound financial standing.

Working Note:
\[ \text{Absolute Change} = \text{Current Year Value} - \text{Previous Year Value} \]
\[ \text{Percentage Change} = \left( \frac{\text{Absolute Change}}{\text{Previous Year Value}} \right) \times 100 \]
In simple words: The current assets and current liabilities increased by similar proportions, keeping liquidity stable. Also, the purchase of fixed assets was well-supported by issues of equity share capital.
Exam Tip: Always make sure to write down the formulas for absolute change and percentage change in working notes to score full marks for presentation.

Question 4. Convert the following Income Statement into Common Size Statement and interpret the changes in 2011 in the light of the conditions in 2010.

Answer:
Common Size Income Statement

Comment:
The organization successfully lowered its operational and manufacturing outlays, leading to an expansion in operating income as well as net earnings.
In simple words: In a common-size income statement, everything is calculated as a percentage of net sales. The business did better because it reduced both product and overhead percentages, raising the net profit margin from 9.00% to 15.46%.
Exam Tip: For Common Size Income Statements, remember to set Net Sales as the 100% base. All other items must be calculated as a direct percentage of Net Sales.

Question 5. Following are the balance sheets of Reddy Limited as on 31 March, 2011 and 2012. Analyse the financial position of the company with the help of the Common Size Balance Sheet.

Answer:
Common Size Balance Sheet of Reddy Limited as on March 11, 2011 and 2012

Comments:
(i) Even though both short-term holdings and obligations fell, the current ratio registered an overall improvement.
(ii) The contraction in liquid cash reserves suggests possible struggles in meeting immediate payment deadlines.
(iii) The growth in non-current properties combined with higher equity indicates that acquisitions were financed via permanent capital pools.

In simple words: This common-size balance sheet shows that the company shifted more of its resource base into long-term fixed assets (which rose from 51.88% to 70.14%), while reducing its current assets.
Exam Tip: For Common Size Balance Sheets, always make sure the total of assets is labeled as 100.00% and total of liabilities + capital is labeled as 100.00%.

Question 6. The accompanying balance sheet and profit and loss account related to SUMO Logistics Private Limited. Convert these into Common Size Statements. Previous Year = 2010, Current Year = 2011
Balance Sheet (Rs. in '000):

Income Statement (Rs. in '000):

Answer:
Common Size Balance Sheet of SUMO Logistics Private Limited as on 2010 and 2011

Common Size Income Statement of SUMO Logistics Private Limited for the year ended 2010 and 2011

In simple words: This represents both the Balance Sheet and Income Statement in a format where all components are shown as percentages of a common base (Total Assets/Liabilities for the Balance Sheet, and Net Sales for the Income Statement), which makes it easy to compare across years.
Exam Tip: Be extra careful when calculating percentages for elements that are subtracted (like sales returns or taxes). Clearly mention whether they represent additions or deductions.

Question 7. From the following particulars extracted from P&L Account of ‘Prashanth Limited, you are required to calculate trend percentages

Answer:
Trend Percentages (Base Year 2003 = 100)

Formula used:\[ \text{Trend Percentage} = \frac{\text{Value of Present Year}}{\text{Value of Base Year}} \times 100 \]
In simple words: Trend percentages show how each item has grown or shrunk compared to the first year (2003), which is kept as the baseline of 100%.
Exam Tip: Keep the base year figures exactly at 100.00% for all columns. For other years, divide the current amount by the base year's amount and multiply by 100.

Question 8. Calculate trend percentages from the following figures of ABC Limited, taking 2000 as base and interpret them.

Answer:
Trend Percentages (Base Year 2000 = 100)

Formula used:
\[ \text{Trend Percentage} = \frac{\text{Present Year Value}}{\text{Base Year Value}} \times 100 \]

Interpretations
(i) Turnover figures show a steady and uninterrupted upward trajectory throughout this duration.
(ii) Inventory levels rose in tandem with expanding sales volumes.
(iii) Earnings expanded at a faster pace during the initial periods than in subsequent ones, suggesting that production and overhead expenses rose during the final stages.
In simple words: This analysis shows that while sales and stocks grew consistently, profitability grew slower in the later years because costs and expenses increased.
Exam Tip: When writing interpretations for trend percentages, compare the growth rates of different metrics (e.g. Sales vs Profit) to show depth in your analytical skills.

Question 9. From the following data relating to the liabilities side of balance sheet of Madhuri Limited, as on 31st March, 2006, you are required to calculate trend percentages taking 2002 as the base year.

Answer:
Trend Percentage (Base Year 2002 = 100)

In simple words: This trend table demonstrates the growth of the company's liability components relative to the base year of 2002.
Exam Tip: Be sure to compute sub-totals like Shareholders' Fund and Total Liabilities separately, then calculate the trend percentages on those sub-totals independently.

Effects of Revised Schedule VI on Tools of Analysis of Financial Statements

As per the revised Schedule VI part II, the standard format of a Profit and Loss Statement is structured as follows:

Question 10. Prepare comparative statements from the following.

Answer:
Comparative Statement of Profit and Loss for the year ended 31st March, 2012

In simple words: A comparative profit and loss statement compares revenue, expenses, and taxes side-by-side for two periods, calculating the actual value changes and percentage shifts.
Exam Tip: Always deduct tax (at the given rate) from Profit Before Tax to find Profit After Tax. Carry out comparative percentage calculations for both Profit Before Tax and Tax to maintain formatting consistency.