Key Points at a Glance

Financial statements are formal records of a firm's financial activities — the Trading & Profit/Loss Account shows income/expenses; the Balance Sheet shows assets and liabilities on a date; the Cash Flow Statement (AS-3) tracks inflows and outflows.

Objectives of financial statement analysis: assessing liquidity (short-term solvency), profitability (earnings capacity), solvency (long-term debt-servicing), efficiency (asset utilisation) and growth potential of a business.

Five main techniques of financial statement analysis: (i) Comparative statements (year-on-year change), (ii) Common-size statements (each item as % of total), (iii) Trend analysis (base year = 100), (iv) Ratio analysis (mathematical relationships), (v) Fund flow / Cash flow analysis.

Key financial ratios: Current Ratio (Current Assets ÷ Current Liabilities; ideal 2:1); Quick Ratio (ideal 1:1); Gross Profit Ratio (Gross Profit ÷ Net Sales × 100); Debt-Equity Ratio (ideal ≤ 2:1 for manufacturing firms); Return on Equity (Net Profit ÷ Shareholders' Equity × 100).

Cash Flow Statement (AS-3, ICAI): classifies cash flows into three activities — (a) Operating (core business), (b) Investing (purchase/sale of assets), (c) Financing (loans, dividends, share capital). Mandatory for listed companies and companies with paid-up capital ≥ ₹50 lakh or turnover ≥ ₹2 crore.

Two methods of preparing Cash Flow Statement: Direct Method (lists actual cash receipts and payments from operations — preferred by ICAI for disclosure) and Indirect Method (adjusts net profit for non-cash items like depreciation, changes in working capital).

Responsibility Accounting: a system that assigns accountability for revenues/costs to specific responsibility centres — (i) Cost Centre (responsible for costs only, e.g., production dept.), (ii) Revenue Centre (responsible for revenues only, e.g., sales dept.), (iii) Profit Centre (responsible for both revenues and costs, e.g., a division), (iv) Investment Centre (responsible for profits and capital employed, e.g., a subsidiary).

Social Accounting (Social Responsibility Accounting): measures and reports a firm's social costs (pollution, resource depletion) and social benefits (employment, community development) alongside financial performance. Goes beyond traditional accounting to include stakeholders — employees, community, environment.

Human Resource Accounting (HRA): a branch of social/responsibility accounting that quantifies the value of human capital in monetary terms. Two main approaches: Historical Cost Method (actual recruitment + training costs) and Replacement Cost Method (cost to replace an employee). Introduced by Rensis Likert in the 1960s.

Environmental Accounting: integrates environmental costs (pollution control, natural resource depletion) into national/corporate accounting. At the national level, it is part of Green GDP (GDP adjusted for environmental degradation); at the corporate level, it forms part of Triple Bottom Line (People, Planet, Profit) reporting.

Limitations of Financial Statement Analysis: (a) Based on historical data — not predictive, (b) Ignores non-monetary factors (goodwill, morale), (c) Seasonal businesses give misleading ratios, (d) Different accounting policies across firms make comparison difficult, (e) Inflation distorts balance sheet values.

Trend Analysis: selects a base year (index = 100) and expresses subsequent years' figures as percentages of the base year. Helps identify growth patterns, cyclical movements and structural changes over 5–10 years. Two methods: Percentage trend series and Graphic / charted presentation.