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

Typically, the income statements and balance sheets are prepared in a comparative form to undertake such an analysis. A vertical common size income statement is a financial statement that expresses each item as a percentage of total revenue. Doing so allows for easy comparison of different expense categories and helps identify trends in the company’s income statement over time. Common size financial statements help to analyze and compare a company’s performance over several periods with varying sales figures. The common size percentages can be subsequently compared to those of competitors to determine how the company is performing relative to the industry.

Ratios can be compared with ratios of previous financial year ratios as well as industry standards. A common size balance sheet is a comparative analysis of a company’s performance over a period, used to determine how the company is using its assets. Each line item on a balance sheet, statement of income, or statement of cash flows is divided by revenue or sales.

One item of note is the Treasury stock in the balance sheet, which had grown to more than negative 100% of total assets. But rather than act as an alarm for you, it indicates the company had been hugely successful in generating cash to buy back shares, far exceeding what it had retained on its balance sheet. Common size financial statements are used to make it easier to compare a company to its competitors and to identify significant changes in a company’s financials. More clearly in terms of the ratio or percentage of each item in the income statement as a percentage of the company’s total sales. It doesn’t include any other expenses into account except the cost of goods sold.

Benefits of Using Common-Size Statements

The common size financial statements are an analytical approach used to understand how a company allocates its resources across various balance sheet and income statement accounts. These financial statements help individuals determine a business’s profitability, liquidity, and solvency position. Moreover, they enable one to compare financial figures from at least two accounting periods. Individuals can also identify the strengths and weaknesses of an organization and compare its performance against other businesses in the industry by preparing this statement. A horizontal common-size income statement is a financial statement that compares the percentage change of each item from one period to another. It helps identify the relative importance of different income statement items and highlights company performance changes over time.

It means that the company is not giving much credit to debtors, whereas it is enjoying the credit period from its creditors. Stock analysis is the evaluation of a particular trading instrument, an investment sector, or the market as a whole. Stock analysts attempt to determine the future activity of an instrument, sector, or market. INVESTMENT BANKING RESOURCESLearn the foundation of Investment banking, financial modeling, valuations and more.

It helps the investors determine the organization’s leverage position and risk level. Such a financial statement is based on the financial data of at least two periods, usually a year. Businesses can compare their performance with the industry’s average performance using these financial statements.

These increased by 33% which is much higher as against the increase in net sales that was just 12%. Thus, this entire scenario indicates that it was quite challenging to sell the goods during 2018. On the other hand, the current liabilities have decreased by Rs 27,000 only. Now, such a change does not have a negative impact on the liquidity position of M/s Kapoor and Co. This is because current assets have decreased by 33.9% whereas current liabilities have declined by 51.5%. Compare performance with the Industry Performance –Helps to compare one company’s performance with another company or the industry’s average performance.

What Is a Common Size Income Statement?

Moreover, it enables entities to spot trends, know about managers’ performance, and evaluate new offerings without looking at different individual financial statements. We will cover it in more detail below, but notice the R&D expense that averages close to 1.5% of revenues in 2020 and 2021. The common size strategy from a balance sheet perspective lends insight into a firm’s capital structure and how it compares to its rivals.

Examples include oil & gas, automobiles, real estate, metals & mining. Invested In Fixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Financial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability.

Summary- Comparative vs Common Size Statement

This analysis helps each of the stakeholders to understand the long-term financial position of a business. Helps in Forecasting –It also helps in forecasting because it provides the past trend of the company based on which the management can forecast the company’s financial position. A vertical financial statement is a type of common-size statement that expresses all values as percentages of the base value in the same year. Because the analysis is performed from the top down, these financial statements are called vertical. The following conclusions can be derived after converting the same common-size financial statements and comparing them over different periods. ProfitabilityProfitability refers to a company’s ability to generate revenue and maximize profit above its expenditure and operational costs.

It is measured using specific difference between comparative and common size statements such as gross profit margin, EBITDA, and net profit margin. As seen above, the common size statement can give you a lot of better insights into the company’s financial position than when you look at the same otherwise. Viewing this financial statement, one can get an idea of the impact of business decisions on a business’s bottom line.

• Expense AccountExpense accounting is the accounting of business costs incurred to generate revenue.
• Therefore, only a comparison with other balance sheets will not give the correct picture of the company’s trend.
• It is not another type of income statement, but it is just one technique used by financial managers to analyze a company’s income statement.
• A common size financial statement displays line items as a percentage of one selected or common figure.
• Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year.

The organization’s management team utilized the information to take corrective measures. It trained its workers to lower labor costs and procured raw materials at a cheaper price. All public companies in the U.S. must publish these financial statements in 10-Q and 10-K reports to fulfill the requirement of the Securities and Exchange Commission or SEC. Individuals can also utilize such statements to compare different organizations in the same industry, assuming they adhere to identical accounting principles. Moreover, companies can use this statement to understand which business aspects require improvements.

In continuation of the above common size example, let us now compare two-year balance sheets of the same company. When we perform a common size, the data provides financial insights. This method allows for easy year-over-year comparison of a company’s financial data and enables comparison between companies of different sizes. First, such statements are often useless when comparing two businesses’ financial figures because a common base does not exist. Let us look at the following points to understand the importance of these financial statements.

Describe the different techniques of financial analysis and explain the limitations of financial analysis. It helps in evaluating the relative financial status of a firm comparison to other competitive firms. This shows the relative importance of the individual figures in the statement. The results are expressed in both forms – percentages as well as pictorial form. This statement also enables a comparison of the expenses and revenues. It shows previous financial results side by side along with its change in amount/percentage.

Comparative Income Statement

Published financial statements are common size statements that contain financial results for the respective accounting period. In the above example, if the results were presented for a single accounting period, it is a common size statement. Common size statements are useful in comparing results with similar companies. Generally accepted accounting principles are based on consistency and comparability of financial statements. A common size income statement makes it easier to see what’s driving a company’s profits. The common size percentages also help to show how each line item or component affects the financial position of the company.

On the other hand, different items of Balance Sheet such as Fixed Assets, Current Assets, Share Capital etc are expressed in terms of percentage of Total of Balance Sheet. These percentage figures are easily comparable with that of the previous years’ and with that of the figures of other firms in the same industry i.e., inter-firm comparison) as well. Ratio analysis is a total for analysing the financial statements of any enterprise.

Analyse the financial position of the company with the help of the Common Size Balance Sheet. Prepare a Comparative Balance Sheet and study the financial position of the company. Simultaneously the company has tried to reduce its costs to improve its profit margin. This common size statement prepares the references for the stakeholders. The statements are useful to compare results with their previous financial years. This analysis shows the previous year’s financial results which occur side by side along with the changes in the amount or its percentage.

It is reported annually, quarterly or monthly as the case may be in the business entity’s income statement/profit & loss account. Accounts PayableAccounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period. Debt To Equity RatioThe debt to equity ratio is a representation of the company’s capital structure that determines the proportion of external liabilities to the shareholders’ equity.

Based on the accounting equation, this also equals total liabilities and shareholders’ equity, making either term interchangeable in the analysis. It is also possible to use total liabilities to indicate where a company’s obligations lie and whether it is being conservative or risky in managing its debts. The standard figure used in the analysis of a common size income statement is total sales revenue. The common size percentages are calculated to show each line item as a percentage of the standard figure or revenue. The standard figure that is used in the analysis of a common size income statement is the total sales revenue.

One column shows the current year’s financial position, whereas the other column shows the previous year’s financial situation. This helps investors or other stakeholders easily understand and analyze the company’s financial performance against last year. Common-size financial statements are very useful when comparing financial data between different companies and especially across different industries. Because of size, currency and other differences between financial statements, it may be difficult to gauge whether a certain figure is normal, too high or too low. Common-size analysis standardizes financial statements and allows for an effective comparison.

Common size statements and financial ratios are the two tools employed in vertical analysis. When comparing any two common size ratios, it is important to make sure that they are computed by using the same base figure. For example, large drops in the company’s profits in two or more consecutive years may indicate that the company is going through financial distress. Similarly, considerable increases in the value of assets may mean that the company is implementing an expansion or acquisition strategy, potentially making the company attractive to investors. Furthermore, this analysis is supported by the increase in the advertisement expenses of the company for the year 2018.

From an investor’s perspective, a common size income statement helps spot patterns in the company’s performance that a basic income statement may not uncover. Firstly, specify absolute figures of items such as cost of goods sold, net sales, selling expenses, office expenses, etc. relating to the accounting periods considered for analysis. These amounts are mentioned in Column I and Column II of the comparative income statement. A comparative income statement showcases the operational results of the business for multiple accounting periods. It helps the business owner to compare the results of business operations over different periods of time.

Horizontal analysis is used in financial statement analysis to compare historical data, such as ratios or line items, over a number of accounting periods. The common size version of this income statement divides each line item by revenue, or $100,000. COGS divided by $100,000 is 50%, operating profit divided by $100,000 is 40%, and net income divided by $100,000 is 32%. As we can see, gross margin is 50%, operating margin is 40%, and the net profit margin is 32%–the common size income statement figures. Answer Financial Analysis has great importance to various accounting users on various matters.

• Ratio analysis establishes relationship between two financial statements.
• Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples.
• Fixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time.
• The common size income statement presents every line item in a company’s income statement as a percentage of sales.
• As we can see, gross margin is 50%, operating margin is 40%, and the net profit margin is 32%–the common size income statement figures.
• Long-term borrowings have decreased by 1%; some marginal repayments of loans must have happened.

Below is an example of a common size balance sheet for technology giant International Business Machines . Running through some of the examples touched on above, we can see that long-term debt averages around 34% of total assets over the two-year period, which reasonable. Cash ranges between 5% and 8.5% of total assets, and short-term debt accounted for about 5% of total assets over the past two years. All three of the primary financial statements can be put into a common size format. Financial statements in dollar amounts can easily be converted to common size statements using a spreadsheet.

Share CapitalShare capital refers to the funds raised by an organization by issuing the company’s initial public offerings, common shares or preference stocks to the public. It appears as the owner’s or shareholders’ equity on the corporate balance sheet’s liability side. Compute e difference between each item’s current and previous years’ values to get the absolute change.