Financial Statement Analysis Exercise Solutions | KalviGavani

How to Use This Page

Solve every exercise question on your own first, then compare your answers below. Focus on understanding why each answer is correct — that builds exam confidence. For numerical questions, practise the format and calculations on paper.

Key Concepts (Quick Recap)

• Financial statement analysis — The process of evaluating a company's financial statements to understand its profitability, solvency, and operational efficiency.
• Comparative statements — Financial statements of two or more years placed side by side, showing absolute changes and percentage changes.
• Common-size statements — Financial statements where each item is expressed as a percentage of a common base (net sales for income statement, total assets/liabilities for balance sheet).
• Horizontal analysis — Comparison of financial data across time periods (used in comparative statements).
• Vertical analysis — Expression of each item as a percentage of a base figure within the same period (used in common-size statements).
• Trend analysis — Comparison of financial data over several years to identify patterns and trends.
• Formula for percentage change — Percentage Change = (Current Year − Previous Year) / Previous Year × 100.
• Base year — The year used as a reference point for comparison. Always the earlier year in comparative analysis.
• Common-size income statement — Each item expressed as a percentage of net sales (revenue from operations).
• Common-size balance sheet — Each item expressed as a percentage of total assets (or total liabilities + equity).

I. Choose the Best Answer (MCQs)

Q1. A comparative statement shows .............. (a) each item as a percentage of net sales (b) absolute changes and percentage changes between periods (c) only the current year's figures (d) projected future figures

Q2. In a common-size income statement, each item is expressed as a percentage of .............. (a) total assets (b) net profit (c) net sales (d) total liabilities

Q3. Percentage change in a comparative statement is calculated as .............. (a) (Current Year / Previous Year) × 100 (b) (Previous Year − Current Year) / Current Year × 100 (c) (Current Year − Previous Year) / Previous Year × 100 (d) (Current Year + Previous Year) / 2 × 100

Q4. Horizontal analysis is also known as .............. (a) vertical analysis (b) time-series analysis (c) cross-sectional analysis (d) common-size analysis

Q5. In a common-size balance sheet, the base is .............. (a) net sales (b) net profit (c) total assets (d) current assets

Q6. Which of the following is a limitation of financial statement analysis? (a) It helps in forecasting (b) It ignores price-level changes (c) It is easy to understand (d) It uses accounting data

II. Fill in the Blanks

1. The process of evaluating financial statements to assess profitability and solvency is called financial statement analysis. 2. In a comparative statement, the base year is the previous year. 3. In a common-size income statement, all items are expressed as a percentage of net sales. 4. In a common-size balance sheet, all items are expressed as a percentage of total assets. 5. Horizontal analysis compares financial data across time periods. 6. Vertical analysis is used in common-size statements. 7. If sales increase from ₹5,00,000 to ₹6,00,000, the percentage increase is 20%.

III. True or False (with corrections for false statements)

IV. Match the Following

V. Answer Briefly

Q1. What is financial statement analysis?

Financial statement analysis is the process of evaluating a company's financial statements (Balance Sheet, Income Statement, Cash Flow Statement) to assess its financial health, profitability, solvency, and operational efficiency. It involves using various tools like comparative statements, common-size statements, ratio analysis, and trend analysis.

Q2. Distinguish between horizontal analysis and vertical analysis.

| Feature | Horizontal Analysis | Vertical Analysis | |---|---|---| | Direction | Across time periods | Within a single period | | Comparison | Year-to-year changes | Each item as % of a base | | Used in | Comparative statements | Common-size statements | | Focus | Trends over time | Proportional relationships | | Example | Sales grew 20% from 2023 to 2024 | Cost of goods is 60% of sales |

Q3. What is a comparative statement? What are its advantages?

A comparative statement presents financial data of two or more years side by side, showing absolute changes (in rupees) and percentage changes. Advantages: 1. Shows the direction of change (increase or decrease) 2. Indicates the magnitude of change (absolute and percentage) 3. Helps identify trends over time 4. Facilitates inter-period comparison 5. Easy to understand and interpret

Q4. What is a common-size statement?

A common-size statement is a financial statement in which each item is expressed as a percentage of a common base figure: - Common-size income statement: Each item as a percentage of net sales (revenue from operations) - Common-size balance sheet: Each item as a percentage of total assets This allows comparison between companies of different sizes and between different periods of the same company.

Q5. State any four limitations of financial statement analysis.

1. Ignores price-level changes — Based on historical cost; does not account for inflation. 2. Not free from bias — Financial statements may be influenced by the personal judgement of accountants (e.g., depreciation method, provision for doubtful debts). 3. Qualitative factors ignored — Only monetary data is considered; factors like management quality, employee satisfaction, and market reputation are ignored. 4. Window dressing — Companies may manipulate financial statements to present a better picture than reality.

VI. Answer in Detail

Q1. Prepare a comparative income statement from the following data and comment on the performance.

| Particulars | 2023 (₹) | 2024 (₹) | |---|---|---| | Revenue from Operations | 10,00,000 | 12,00,000 | | Cost of Goods Sold | 6,00,000 | 7,20,000 | | Operating Expenses | 1,00,000 | 1,30,000 | | Other Incomes | 50,000 | 40,000 | | Income Tax | 30% | 30% |

Comparative Income Statement for the years ended 31st March 2023 and 2024

| Particulars | 2023 (₹) | 2024 (₹) | Absolute Change (₹) | % Change | |---|---|---|---|---| | Revenue from Operations | 10,00,000 | 12,00,000 | +2,00,000 | +20% | | Less: Cost of Goods Sold | 6,00,000 | 7,20,000 | +1,20,000 | +20% | | Gross Profit | 4,00,000 | 4,80,000 | +80,000 | +20% | | Less: Operating Expenses | 1,00,000 | 1,30,000 | +30,000 | +30% | | Operating Profit | 3,00,000 | 3,50,000 | +50,000 | +16.67% | | Add: Other Incomes | 50,000 | 40,000 | −10,000 | −20% | | Profit Before Tax | 3,50,000 | 3,90,000 | +40,000 | +11.43% | | Less: Income Tax (30%) | 1,05,000 | 1,17,000 | +12,000 | +11.43% | | Profit After Tax | 2,45,000 | 2,73,000 | +28,000 | +11.43% | Comments: - Revenue increased by 20% — good top-line growth. - Gross profit also increased by 20% — the company maintained its gross profit margin (40%). - Operating expenses rose by 30%, faster than revenue growth (20%) — this is concerning and needs attention. - Operating profit grew only 16.67%, lagging behind revenue growth due to higher operating expenses. - Profit after tax increased by 11.43% — positive but lower than revenue growth, indicating cost pressure from operating expenses.

Q2. Prepare a common-size income statement from the following data.

| Particulars | 2023 (₹) | 2024 (₹) | |---|---|---| | Revenue from Operations | 8,00,000 | 10,00,000 | | Cost of Goods Sold | 4,80,000 | 5,50,000 | | Operating Expenses | 1,20,000 | 1,50,000 | | Other Incomes | 40,000 | 60,000 | | Income Tax | 30% | 30% |

Common-Size Income Statement

| Particulars | 2023 (₹) | 2023 (%) | 2024 (₹) | 2024 (%) | |---|---|---|---|---| | Revenue from Operations | 8,00,000 | 100% | 10,00,000 | 100% | | Less: Cost of Goods Sold | 4,80,000 | 60% | 5,50,000 | 55% | | Gross Profit | 3,20,000 | 40% | 4,50,000 | 45% | | Less: Operating Expenses | 1,20,000 | 15% | 1,50,000 | 15% | | Operating Profit | 2,00,000 | 25% | 3,00,000 | 30% | | Add: Other Incomes | 40,000 | 5% | 60,000 | 6% | | Profit Before Tax | 2,40,000 | 30% | 3,60,000 | 36% | | Less: Income Tax (30%) | 72,000 | 9% | 1,08,000 | 10.8% | | Profit After Tax | 1,68,000 | 21% | 2,52,000 | 25.2% | Interpretation: - COGS decreased from 60% to 55% of sales — improved cost efficiency. - Gross profit improved from 40% to 45% — better profitability. - Operating expenses remained stable at 15% — well-controlled. - Profit after tax improved from 21% to 25.2% — overall better financial performance.

Q3. Prepare a common-size balance sheet from the following data.

| Particulars | 2023 (₹) | 2024 (₹) | |---|---|---| | Equity Share Capital | 5,00,000 | 6,00,000 | | Reserves and Surplus | 2,00,000 | 3,00,000 | | Long-term Borrowings | 3,00,000 | 2,50,000 | | Current Liabilities | 2,00,000 | 2,50,000 | | Fixed Assets | 8,00,000 | 9,00,000 | | Current Assets | 3,00,000 | 4,50,000 | | Non-current Investments | 1,00,000 | 50,000 |

Common-Size Balance Sheet

Total Assets: 2023 = ₹12,00,000; 2024 = ₹14,00,000

| Particulars | 2023 (₹) | 2023 (%) | 2024 (₹) | 2024 (%) | |---|---|---|---|---| | Equity and Liabilities | | | | | | Equity Share Capital | 5,00,000 | 41.67% | 6,00,000 | 42.86% | | Reserves and Surplus | 2,00,000 | 16.67% | 3,00,000 | 21.43% | | Shareholders' Funds | 7,00,000 | 58.33% | 9,00,000 | 64.29% | | Long-term Borrowings | 3,00,000 | 25% | 2,50,000 | 17.86% | | Current Liabilities | 2,00,000 | 16.67% | 2,50,000 | 17.86% | | Total | 12,00,000 | 100% | 14,00,000 | 100% | | Assets | | | | | | Fixed Assets | 8,00,000 | 66.67% | 9,00,000 | 64.29% | | Non-current Investments | 1,00,000 | 8.33% | 50,000 | 3.57% | | Current Assets | 3,00,000 | 25% | 4,50,000 | 32.14% | | Total | 12,00,000 | 100% | 14,00,000 | 100% | Interpretation: - Shareholders' funds increased from 58.33% to 64.29% — improved financial independence. - Long-term borrowings decreased from 25% to 17.86% — reduced reliance on debt. - Current assets increased from 25% to 32.14% — improved liquidity position. - Fixed assets decreased slightly in proportion (66.67% to 64.29%) — more balanced asset structure.

Q4. Explain the tools of financial statement analysis.

1. Comparative Statements: Present financial data of two or more years side by side, showing absolute changes and percentage changes. Useful for identifying trends. 2. Common-Size Statements: Express each item as a percentage of a common base (net sales for income statement, total assets for balance sheet). Useful for comparing companies of different sizes. 3. Trend Analysis: Calculate percentage changes for several years using a base year. Helps identify long-term patterns in revenue, expenses, profits, etc. 4. Ratio Analysis: Calculate financial ratios (liquidity, solvency, activity, profitability) to evaluate relationships between different financial items. 5. Cash Flow Analysis: Analyse the inflows and outflows of cash from operating, investing, and financing activities. 6. Fund Flow Analysis: Analyse changes in working capital between two balance sheet dates to identify sources and uses of funds.

Common Mistakes to Avoid

• Using the wrong base for percentage change: Always use the previous year (base year) as the denominator. Percentage Change = (Current − Previous) / Previous × 100.
• Confusing comparative and common-size statements: Comparative statements show absolute + percentage changes across time; common-size statements show proportional relationships within one period.
• Using wrong base in common-size statements: Income statement base = net sales (revenue from operations); Balance sheet base = total assets. Do NOT use net profit as the base.
• Forgetting to calculate absolute change: Comparative statements must show both absolute change (₹) and percentage change (%).
• Not commenting on the results: Always interpret the figures — state whether the change is favourable or unfavourable and why.
• Treating all percentage increases as positive: A 20% increase in expenses is unfavourable, while a 20% increase in revenue is favourable. Context matters.

Exam Checklist

• [ ] Can you distinguish between horizontal and vertical analysis?
• [ ] Can you prepare a comparative income statement with absolute and percentage changes?
• [ ] Can you prepare a comparative balance sheet?
• [ ] Can you prepare a common-size income statement (base = net sales)?
• [ ] Can you prepare a common-size balance sheet (base = total assets)?
• [ ] Can you interpret the results of comparative and common-size statements?
• [ ] Can you list the tools and limitations of financial statement analysis?
• [ ] Can you correctly calculate percentage change using the base year as denominator?