Analysis of Financial Statements

Financial statements by themselves are just figures. Analysis of financial statements is the process of breaking down, comparing and interpreting those figures to judge the firm's profitability, solvency and efficiency — turning raw data into useful conclusions. Analysis means methodical classification of the data; interpretation means drawing meaning from it. The two go together.

Analysis can be of two kinds by direction:

• Horizontal (dynamic) analysis — comparing figures across several years (e.g. comparative statements). It shows trends over time.
• Vertical (static) analysis — comparing items within one year as a percentage of a common base (e.g. common-size statements, ratios).

The main tools of analysis are: comparative statements, common-size statements, accounting ratios, cash flow statement, and trend analysis.

Like all accounting, analysis has limitations the student must respect:

• It is only as good as the financial statements themselves (which carry their own limits — historical cost, judgement, window dressing).
• It ignores qualitative (non-money) factors such as management quality.
• It can be misleading if different firms use different accounting methods (no comparability), or if price-level changes are ignored.
• Ratios and percentages can be window-dressed.

So analysis is powerful for decision-making, but its conclusions must be drawn with judgement, not mechanically.

A comparative statement places the figures of two or more years side by side and shows the absolute change and the percentage change between them — this is horizontal analysis. It is prepared for both the Statement of Profit and Loss (Comparative Income Statement) and the Balance Sheet (Comparative Balance Sheet).

The columns are: Particulars, figures for Year 1, figures for Year 2, Absolute Change (Year 2 − Year 1), and Percentage Change (Absolute change ÷ Year 1 × 100).

The power of the comparative statement is that the percentage change highlights trends that raw figures hide. In the example, revenue rose 20% but profit rose 35% — meaning costs grew more slowly than sales, a healthy sign of improving efficiency. Reading the directions and sizes of these changes lets an analyst spot whether a business is growing, where its costs are rising, and whether profitability is improving.

For the Balance Sheet, the same method shows how assets, liabilities and capital have changed — for example, a large rise in borrowings with little rise in fixed assets might signal funds being used for working capital or losses. The key formula to remember: % change = (Absolute change ÷ previous-year figure) × 100.

A common-size statement expresses every item as a percentage of a common base — this is vertical analysis. Because everything is reduced to a percentage, firms of very different sizes (or different years) can be compared on the same footing.

• In a Common-Size Income Statement, every item is shown as a percentage of Revenue from Operations (taken as 100%).
• In a Common-Size Balance Sheet, every item is shown as a percentage of Total Assets (or total Equity & Liabilities), taken as 100%.

The strength of common-size analysis is that it reveals structure and proportion. In the table, materials eat up 60% of revenue and the firm keeps 25% as profit before tax. Comparing this with another firm (or another year) instantly shows who controls costs better, regardless of absolute size. For the balance sheet, it shows what proportion of funds is tied up in fixed vs current assets, and how much financing comes from equity vs debt.

So the two statements complement each other: comparative statements answer "how much has each item changed over time?" while common-size statements answer "what is each item's share of the whole?" Together they are the backbone of statement analysis, leading naturally into ratio analysis. The base formula: % = (item ÷ base) × 100, where the base is revenue (income statement) or total assets (balance sheet).