Class 12 Book Keeping and Accountancy Chapter 9: Analysis of Financial Statements

Key concepts: Analysis of Financial Statements

Financial statement analysis

Studying the Balance Sheet and Profit and Loss A/c in two steps: analysis (orderly classification of the data) and interpretation (explaining what the figures mean) to judge profitability, solvency and strength.

Comparative financial statement

A statement placing figures of two or more years side by side, with the absolute change and the percentage change of each item, so that growth or decline is easy to see.

Common size statement

A statement in which every item is shown as a percentage of a common base: Net Sales for the income statement and Total Fund Available for the balance sheet. Useful for inter-firm comparison.

Cash flow statement

A statement of cash inflows and outflows for a period, grouped under AS-3 into operating, investing and financing activities. It explains the change in cash balance and helps short-term planning.

Ratio analysis

A ratio is a number showing the relationship between two accounting figures. Using ratios to judge a firm's performance, and to compare it over years or with other firms, is ratio analysis.

Liquidity ratios

Current ratio (current assets / current liabilities, ideal 2:1) and liquid or quick ratio (quick assets / quick liabilities, ideal 1:1) measure the ability to pay short-term debts.

Income statement ratios

Gross profit, operating profit and net profit ratios compare each profit with net sales; operating ratio compares cost of goods sold plus operating expenses with net sales.

Combined ratios (ROI and ROCE)

Return on investment and return on capital employed compare profit with the capital employed in the business, showing how well the funds are being used.

Quick revision: important points

• Absolute change = Current year - Previous year; % change = Absolute change / Previous year x 100.
• Current ratio = Current assets / Current liabilities (ideal 2:1).
• Quick assets = Current assets - (Stock + Prepaid expenses); quick liabilities = Current liabilities - Bank overdraft.
• GP ratio = Gross profit / Net sales x 100; Net sales = Sales - Sales returns.
• Operating ratio = (Cost of goods sold + Operating expenses) / Net sales x 100.
• ROI = Net profit / Capital employed x 100; Capital employed = Fixed assets + Current assets - Current liabilities.

Practice MCQs with answers

1. Which are the two main financial statements prepared by a business?

   1. Cash Book and Ledger
   2. Trial Balance and Journal
   3. Balance Sheet and Profit and Loss Account
   4. Cash Budget and Sales Budget
   Show answer

   Answer: C. Balance Sheet and Profit and Loss Account
   The Balance Sheet is the position statement and the Profit and Loss A/c is the income statement.

2. Explaining the meaning and significance of the classified figures in financial statements is called

   1. Analysis of data
   2. Interpretation of data
   3. Window dressing
   4. Recording of data
   Show answer

   Answer: B. Interpretation of data
   Analysis arranges the data in an orderly way; interpretation explains what that data means.

3. The efficiency and harmony of a firm's management do not appear anywhere in its financial statements. This shows which limitation?

   1. Historical cost
   2. Window dressing
   3. Static statement
   4. Qualitative information is ignored
   Show answer

   Answer: D. Qualitative information is ignored
   Only items that can be measured in money are shown, so quality factors like management efficiency are left out.

4. To show a rosy picture, management overvalues closing stock and hides purchases made at year end. This is known as

   1. Window dressing
   2. Common sizing
   3. Personal judgment
   4. Historical costing
   Show answer

   Answer: A. Window dressing
   Deliberately making the statements look better than reality is called window dressing.

5. Financial statements fail to show the effect of changes in prices because they are prepared on the basis of

   1. Market values
   2. Historical cost
   3. Replacement cost
   4. Future estimates
   Show answer

   Answer: B. Historical cost
   Assets are recorded at their original (historical) cost and book values, so price changes are not reflected.

All Class 12 Book Keeping and Accountancy chapters

• Chapter 1: Introduction to Partnership and Partnership Final Accounts
• Chapter 2: Accounts of Not for Profit Concerns
• Chapter 3: Reconstitution of Partnership (Admission of Partner)
• Chapter 4: Reconstitution of Partnership (Retirement of Partner)
• Chapter 5: Reconstitution of Partnership (Death of Partner)
• Chapter 6: Dissolution of Partnership Firm
• Chapter 7: Bills of Exchange
• Chapter 8: Company Accounts - Issue of Shares
• Chapter 9: Analysis of Financial Statements
• Chapter 10: Computer in Accounting

Class 12 Book Keeping and Accountancy notes: all chapters