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Techniques of Financial Statement Analysis
3.1 Comparative Statements
Compares financial data of two or more years side-by-side to reveal:
- Absolute change (₹ increase/decrease)
- Percentage change
Example: If sales in 2022-23 were ₹50 lakh and in 2023-24 ₹65 lakh → absolute change = ₹15 lakh (increase); percentage change = 30%.
Useful for identifying growth trends, stagnation, or decline at a glance.
3.2 Common-Size Statements (Vertical Analysis)
Each line item is expressed as a percentage of a base figure (net sales for P&L; total assets for balance sheet). Enables meaningful comparison across companies of different sizes.
Formula: Common-size % = (Item ÷ Base) × 100
For example, if raw material cost is ₹30 lakh and net sales are ₹100 lakh → raw material as % of sales = 30%. If a competitor's raw material % = 25%, the firm is relatively inefficient.
3.3 Trend Analysis
- A base year is selected and its value set to 100.
- Subsequent years' figures are expressed as trend ratios (index numbers).
- Formula: Trend Ratio = (Current Year Value ÷ Base Year Value) × 100
Interpretation: Trend ratio > 100 = increase; < 100 = decrease. Ideal for identifying long-term growth patterns over 5–10 years.
Two methods (as asked in 2021 PYQ):
- Percentage trend series — arithmetic calculation of percentage change from base year.
- Graphic presentation — trends plotted on graphs for visual interpretation.
3.4 Ratio Analysis
The most widely used technique. A ratio is a mathematical relationship between two accounting figures. Ratios are grouped into:
| Category | Key Ratio | Formula | Ideal Standard |
|---|---|---|---|
| Liquidity | Current Ratio | Current Assets ÷ Current Liabilities | 2:1 |
| Liquidity | Quick Ratio (Acid Test) | (CA − Inventory − Prepaid) ÷ CL | 1:1 |
| Profitability | Gross Profit Ratio | (GP ÷ Net Sales) × 100 | Industry specific |
| Profitability | Net Profit Ratio | (NP ÷ Net Sales) × 100 | Higher the better |
| Profitability | Return on Equity (ROE) | (NP ÷ Shareholders' Equity) × 100 | >15% |
| Solvency | Debt-Equity Ratio | Long-term Debt ÷ Shareholders' Equity | ≤2:1 |
| Solvency | Interest Coverage Ratio | EBIT ÷ Interest Expense | >3 times |
| Efficiency | Stock Turnover Ratio | COGS ÷ Average Inventory | Higher the better |
| Efficiency | Debtors Turnover Ratio | Credit Sales ÷ Average Debtors | Higher the better |
3.5 Fund Flow / Cash Flow Analysis
Fund Flow Statement traces the movement of working capital between two balance sheet dates (sources and applications of funds). Now largely replaced by:
Cash Flow Statement (AS-3): The modern standard — tracks actual cash movements across three activities:
- Operating Activities — cash from core business operations (receipts from customers, payments to suppliers, salaries, taxes paid).
- Investing Activities — cash from purchase/sale of long-term assets (plant, machinery, investments, loans given).
- Financing Activities — cash from raising or repaying capital (issue of shares, debentures, repayment of loans, payment of dividends).