Class 12 Accountancy Part 2 Chapter 4: Analysis of Financial Statements

Analysis of Financial Statements is a crucial chapter that teaches you how to read numbers behind a company's Balance Sheet and Statement of Profit and Loss, and turn them into meaningful conclusions about the business's health, growth, and efficiency. Instead of stopping at raw figures, you learn techniques—Comparative Statements, Common Size Statements, and Trend Analysis—that reveal changes over time and structural relationships within financial data. This chapter matters because board exams frequently ask you to prepare these statements from given figures and interpret percentage changes, and because these same tools are used by real investors, banks, and managers to judge a firm's performance. In this page, you will master the objectives and limitations of financial analysis, the exact format and calculation method for each tool, fully worked numerical examples with steps, common exam traps students fall into, and practice questions with complete step-by-step CBSE-style solutions so you can score full marks confidently.

What is Analysis of Financial Statements?

Financial Statement Analysis means systematically studying the relationship between different items of the Balance Sheet and Statement of Profit and Loss to understand a firm's profitability, liquidity, solvency, and operational efficiency. Raw figures like 'Sales = ₹5,00,000' tell little on their own; analysis converts them into percentages, ratios, and trends that are comparable across years and companies.

The chapter covers three key tools: Comparative Statements (compare two years' figures showing absolute and percentage change), Common Size Statements (express every item as a percentage of a common base like total sales or total assets), and Trend Analysis (study the direction of change over several years using a base year = 100). Objectives include judging earning capacity, financial soundness, and helping management, investors, creditors, and government make informed decisions. Limitations include ignoring price-level changes, qualitative factors, and being based on historical, sometimes window-dressed, data.

Key Terms and Definitions

Comparative Statement: A statement showing figures of two or more accounting periods side by side along with the absolute change and percentage change, to study the direction of growth or decline.
Common Size Statement: A statement in which each item is expressed as a percentage of a common base — Revenue from Operations for the Statement of P&L, and Total Assets/Total Equity & Liabilities for the Balance Sheet.
Trend Analysis: A technique that studies the tendency of items over a series of years by taking one year as the base year (=100) and expressing other years' figures as a percentage of the base year figure.
Absolute Change: The simple numerical difference between the current year figure and the previous year figure (Current Year − Previous Year).
Percentage Change: Absolute Change divided by the Previous Year figure, multiplied by 100; shows the relative rate of change.

How to Prepare a Comparative and Common Size Statement — Step by Step

Step 1: List items in required format — Arrange items of the Balance Sheet as per Schedule III (Equity & Liabilities, then Assets) or P&L items (Revenue, Expenses) in two columns for two years, keeping a similar structure both years.
Step 2: Compute Absolute Change — For each line item calculate: Absolute Change = Current Year Amount − Previous Year Amount. Show as positive (increase) or negative (decrease) in brackets.
Step 3: Compute Percentage Change (Comparative Statement) — Percentage Change = (Absolute Change / Previous Year Amount) × 100. If previous year figure is zero or negative, percentage change cannot be meaningfully computed — mention 'N/A'.
Step 4: Choose the Common Base (Common Size Statement) — For P&L: base = Revenue from Operations (taken as 100). For Balance Sheet: base = Total Assets or Total Equity & Liabilities (taken as 100). Every item is then expressed as % of this base for each year separately.
Step 5: Calculate Common Size Percentage — Common Size % = (Individual Item / Base Figure) × 100, calculated separately for each year — this allows comparison of internal structure regardless of the company's size.
Step 6: Interpret the results — Analyse which items grew/declined significantly, whether the change is favourable, and write a brief interpretation — examiners award marks for correct interpretation, not just calculation.

Fully Worked Examples

Example 1 (Comparative Statement of P&L): Revenue from Operations was ₹8,00,000 in 2022 and ₹10,00,000 in 2023. Total Expenses were ₹6,00,000 in 2022 and ₹7,00,000 in 2023.
Step 1: Absolute Change in Revenue = 10,00,000 − 8,00,000 = ₹2,00,000.
Step 2: % Change in Revenue = (2,00,000/8,00,000)×100 = 25%.
Step 3: Absolute Change in Expenses = 7,00,000 − 6,00,000 = ₹1,00,000; % Change = (1,00,000/6,00,000)×100 = 16.67%.
Step 4: Profit before Tax 2022 = 8,00,000−6,00,000 = ₹2,00,000; 2023 = 10,00,000−7,00,000 = ₹3,00,000.
Step 5: Absolute Change in Profit = ₹1,00,000; % Change = (1,00,000/2,00,000)×100 = 50%.
Final answer: Revenue grew 25%, Expenses grew 16.67%, but Profit grew 50% — showing better cost control leading to higher profitability growth.
Example 2 (Common Size Statement of Balance Sheet): Total Assets = ₹20,00,000, of which Fixed Assets = ₹12,00,000 and Current Assets = ₹8,00,000, for the year 2023.
Step 1: Base = Total Assets = ₹20,00,000 = 100%.
Step 2: Common Size % of Fixed Assets = (12,00,000/20,00,000)×100 = 60%.
Step 3: Common Size % of Current Assets = (8,00,000/20,00,000)×100 = 40%.
Final answer: Fixed Assets form 60% and Current Assets form 40% of total assets — useful to compare capital structure with another year or another firm of different size.
Example 3 (Trend Analysis): Sales figures: 2020 = ₹4,00,000 (base year), 2021 = ₹4,80,000, 2022 = ₹6,00,000.
Step 1: Trend % for 2020 = (4,00,000/4,00,000)×100 = 100 (base).
Step 2: Trend % for 2021 = (4,80,000/4,00,000)×100 = 120.
Step 3: Trend % for 2022 = (6,00,000/4,00,000)×100 = 150.
Final answer: Sales trend is 100, 120, 150 — indicating a consistent upward growth of 20% then further 25% growth on base, useful for forecasting future sales.

Exam Tips and Common Mistakes

Many students lose marks by using the wrong base for percentage change — always divide by the PREVIOUS year figure, never the current year, when computing % change in comparative statements. Another frequent error is mixing up the base for common size statements: use Revenue from Operations for the P&L statement but Total Assets (or Total Equity and Liabilities, which are equal) for the Balance Sheet — never use Net Profit as a base. Always show figures as per Schedule III format with proper headings (Equity and Liabilities, Assets) and present absolute change with correct sign (bracket for decrease). Round percentages to two decimal places unless instructed otherwise, and always write a one-line interpretation at the end since CBSE marking schemes often allocate marks for analysis, not just computation.

Important Points to Remember

Comparative Statements need at least two years' data and show both absolute and percentage change.
Common Size Statements are prepared for a SINGLE year at a time — each year has its own 100% base, they are not compared across years directly like trend analysis.
Trend percentages always take the earliest year as base = 100; all other years are expressed relative to it.
Financial statement analysis is based on historical costs and ignores price-level (inflation) changes, which is a key limitation to mention in theory answers.
Objectives of analysis include assessing profitability, liquidity, solvency, and operational efficiency for different users like shareholders, creditors, employees, and government.
Analysis does not consider qualitative factors like management quality, employee morale, or market reputation.

Practice Questions with Solutions

Q: From the following figures, prepare a Comparative Statement of Profit and Loss: Revenue from Operations 2022 = ₹5,00,000, 2023 = ₹6,50,000; Total Expenses 2022 = ₹3,50,000, 2023 = ₹4,00,000.
A: Step 1: Absolute Change in Revenue = 6,50,000 − 5,00,000 = ₹1,50,000.
Step 2: % Change in Revenue = (1,50,000/5,00,000)×100 = 30%.
Step 3: Absolute Change in Expenses = 4,00,000 − 3,50,000 = ₹50,000; % Change = (50,000/3,50,000)×100 = 14.29%.
Step 4: Profit 2022 = 5,00,000 − 3,50,000 = ₹1,50,000; Profit 2023 = 6,50,000 − 4,00,000 = ₹2,50,000.
Step 5: Absolute Change in Profit = ₹1,00,000; % Change = (1,00,000/1,50,000)×100 = 66.67%.
Final answer: Revenue increased 30%, Expenses increased 14.29%, and Profit increased 66.67%, showing strong improvement in profitability due to controlled expense growth.
Q: Total Assets of a company are ₹15,00,000 comprising Non-Current Assets ₹9,00,000 and Current Assets ₹6,00,000. Prepare the Common Size Balance Sheet percentages for Assets.
A: Step 1: Base = Total Assets = ₹15,00,000 = 100%.
Step 2: Common Size % of Non-Current Assets = (9,00,000/15,00,000)×100 = 60%.
Step 3: Common Size % of Current Assets = (6,00,000/15,00,000)×100 = 40%.
Final answer: Non-Current Assets = 60%, Current Assets = 40% of Total Assets.
Q: Calculate trend percentages for the following Net Profit figures taking 2019 as base year: 2019 = ₹2,00,000, 2020 = ₹2,50,000, 2021 = ₹3,00,000, 2022 = ₹1,50,000.
A: Step 1: Trend % 2019 = (2,00,000/2,00,000)×100 = 100.
Step 2: Trend % 2020 = (2,50,000/2,00,000)×100 = 125.
Step 3: Trend % 2021 = (3,00,000/2,00,000)×100 = 150.
Step 4: Trend % 2022 = (1,50,000/2,00,000)×100 = 75.
Final answer: Trend percentages are 100, 125, 150, 75 — showing growth till 2021 followed by a sharp decline in 2022 that needs investigation.
Q: State any two objectives and any two limitations of Financial Statement Analysis.
A: Step 1: Objectives — (i) To assess the earning capacity/profitability of the firm. (ii) To judge the short-term and long-term solvency/liquidity position of the business for creditors and lenders.
Step 2: Limitations — (i) It ignores price-level changes (inflation), so comparison across years may be misleading. (ii) It is based on historical data and does not consider qualitative aspects like management efficiency or employee satisfaction.
Final answer: Objectives: assessing profitability and solvency. Limitations: ignores inflation and qualitative factors.
Q: Revenue from Operations for a firm is ₹12,00,000 and Cost of Materials Consumed is ₹7,20,000. Calculate the Common Size percentage of Cost of Materials Consumed for the Common Size Statement of Profit and Loss.
A: Step 1: Base for P&L Common Size Statement = Revenue from Operations = ₹12,00,000 = 100%.
Step 2: Common Size % of Cost of Materials Consumed = (7,20,000/12,00,000)×100 = 60%.
Final answer: Cost of Materials Consumed is 60% of Revenue from Operations.

Frequently Asked Questions

What is the main difference between Comparative and Common Size Statements?

A Comparative Statement compares figures of two years showing absolute and percentage change over time, while a Common Size Statement expresses each item of a single year's statement as a percentage of a common base (like Revenue or Total Assets) to study internal structure. Comparative analysis focuses on growth trend between years; common size analysis focuses on proportion within one year.

Which base is used for Common Size Statement of Profit and Loss and Balance Sheet?

For the Statement of Profit and Loss, the base is Revenue from Operations (taken as 100%). For the Balance Sheet, the base is Total Assets or Total Equity and Liabilities, since both sides are equal in total.

Why is Trend Analysis useful for CBSE exam questions?

Trend Analysis shows the direction of change in an item over several years by fixing one year as base = 100, which helps examiners test whether students can identify consistent growth, decline, or fluctuation patterns. It is especially useful for forecasting future performance based on historical trend behaviour.

What are the limitations of financial statement analysis that I should mention in theory answers?

Key limitations include ignoring price-level (inflation) changes, being based on historical costs rather than current values, not considering qualitative factors like management quality, and being subject to distortion if statements are window-dressed. Mentioning at least two of these with brief explanation earns full marks in theory questions.

How should I round off percentage figures in comparative and common size statements?

Unless the question specifies otherwise, round off all percentage figures to two decimal places for accuracy and consistency. Always double check that the previous year figure used as denominator in comparative statements is not zero, as this would make the percentage change undefined.