Class 12 Financial Statement Analysis: Complete Concepts and Practice

Big picture

Financial statements report what happened. Analysis turns those numbers into answers: Can the company pay its bills next month? Is it borrowing too much? Is it selling its stock quickly? Is it earning a good return?

This chapter has four parts. First, the Schedule III format that every company's Balance Sheet and Statement of Profit and Loss must follow; you need to know exactly where each item goes. Then three tools of analysis: comparative statements (change over time), common-size statements (each item as a percentage of a total) and ratio analysis (relationships between items).

Learning goals

• Prepare the Balance Sheet and Statement of Profit and Loss headings under Schedule III, and classify items correctly.

• State the objectives, tools and limitations of financial statement analysis.

• Prepare comparative and common-size statements.

• Calculate and interpret liquidity, solvency, activity and profitability ratios.

• Work out the effect of a transaction on a ratio.

Core ideas

1. The Balance Sheet under Schedule III

An item is current if it will be settled or realised within 12 months (or the operating cycle).

Classifying items: the exam favourites

The Statement of Profit and Loss shows: Revenue from operations; Other income; Total income; Expenses (cost of materials consumed, purchases of stock-in-trade, changes in inventories, employee benefits expense, finance costs, depreciation and amortisation, other expenses); Profit before tax; Tax expense; Profit for the period.

2. Purpose, tools and limitations of analysis

Objectives: judge the company's earning capacity, its short-term solvency (liquidity), its long-term solvency, and the efficiency of its management; compare performance across years and with other firms; help in planning and forecasting.

Tools: comparative statements, common-size statements, ratio analysis, and the cash flow statement.

Limitations:

• Statements are based on historical data; analysis does not predict the future by itself.

• Price-level changes are ignored, so years are not strictly comparable in inflation.

• Qualitative factors (management quality, labour relations, brand) are left out.

• Companies may follow different accounting policies, which spoils comparison.

• Figures can be window-dressed to look better on the balance sheet date.

• The analysis is only as reliable as the statements it uses.

3. Comparative statements

A comparative statement puts two years side by side and shows the absolute change and the percentage change:

Percentage change = Change ÷ Previous year's figure × 100

Comparative Statement of Profit and Loss (₹)

Reading it. Revenue grew 25% while cost of revenue grew only 20%, so profit grew twice as fast as sales. That tells you the company controlled its costs well.

4. Common-size statements

Every item is shown as a percentage of a common base: total of the balance sheet (for a common-size balance sheet) or revenue from operations (for a common-size statement of profit and loss).

Common-size Balance Sheet

Half the funds come from the owners (40 + 10), and 60% of them are tied up in fixed assets. Common-size statements make companies of very different sizes comparable.

5. Ratio analysis: one company, every ratio

All ratios below use the data of Kaveri Ltd for 2024-25.

Balance Sheet (31 March 2025)
Share capital                5,00,000    PPE                       6,60,000
Reserves and surplus         1,00,000    Inventories               1,40,000
10% Debentures               3,00,000    Trade receivables         1,40,000
Trade payables               1,20,000    Cash and cash equivalents 1,00,000
Other current liabilities      40,000    Prepaid expenses            20,000
Total                       10,60,000    Total                    10,60,000

Statement of Profit and Loss
Revenue from operations     15,00,000   (credit revenue 12,00,000)
Cost of revenue from ops    10,50,000
Gross profit                 4,50,000
Operating expenses           1,50,000
Operating profit (PBIT)      3,00,000
Interest on debentures         30,000
Profit before tax            2,70,000
Tax at 30%                     81,000
Profit after tax             1,89,000

Opening inventory 1,60,000; opening trade receivables 1,60,000;
opening trade payables 1,20,000; credit purchases 9,60,000.

Useful totals: current assets = 1,40,000 + 1,40,000 + 1,00,000 + 20,000 = ₹4,00,000; current liabilities = ₹1,60,000; shareholders' funds (equity) = ₹6,00,000; debt = ₹3,00,000; capital employed = 6,00,000 + 3,00,000 = ₹9,00,000.

6. Liquidity ratios

They measure the ability to pay short-term obligations.

Quick assets = Current assets − Inventories − Prepaid expenses = 4,00,000 − 1,40,000 − 20,000 = ₹2,40,000. Inventory is left out because it takes time to sell; prepaid expenses can't be turned into cash at all.

Interpretation. A current ratio around 2:1 and a quick ratio around 1:1 are traditionally considered comfortable. A very high ratio may mean idle cash or excess stock, not just safety.

Working capital = Current assets − Current liabilities = ₹2,40,000.

7. Solvency ratios

They measure the ability to meet long-term obligations.

Shareholders' funds = Share capital + Reserves and surplus (equivalently, Non-current assets + Working capital − Non-current liabilities). A lower debt-equity ratio is safer for lenders; an interest coverage of 10 times means profit could fall a long way before interest became a problem.

8. Activity (turnover) ratios

They measure how efficiently resources are used. Use average figures (opening + closing ÷ 2) when both are available.

Average collection period = 12 months ÷ 8 = 1.5 months (or 365 ÷ 8 ≈ 46 days). Average payment period is also 1.5 months here. Collecting from customers no slower than paying suppliers is a healthy sign.

Finding cost of revenue from operations when it isn't given: Opening inventory + Net purchases + Direct expenses − Closing inventory; or Revenue from operations − Gross profit.

9. Profitability ratios

Operating ratio + Operating profit ratio = 100%, which is a quick check. Capital employed = Shareholders' funds + Non-current liabilities, or Total assets − Current liabilities (10,60,000 − 1,60,000 = ₹9,00,000).

10. Effect of transactions on ratios

A favourite question: "Will this transaction increase, decrease or not change the ratio?" Work it out with the actual effect on numerator and denominator.

Rule for the current ratio when it is above 1:

• An equal decrease in current assets and current liabilities increases the ratio. With 4,00,000 ÷ 1,60,000 = 2.5, paying a creditor ₹40,000 gives 3,60,000 ÷ 1,20,000 = 3.0.

• An equal increase in both decreases the ratio. Buying goods on credit for ₹40,000 gives 4,40,000 ÷ 2,00,000 = 2.2.

Similar reasoning applies to other ratios: for example, issuing debentures for cash increases the debt-equity ratio, and redeeming them reduces it.

A reliable problem-solving routine

1. For classification, decide first whether the item is an asset or a liability, then current or non-current, then the exact sub-heading.

2. For comparative statements, divide the change by the previous year. For common-size statements, divide by the total (balance sheet) or revenue (profit and loss).

3. For a ratio, write the formula first, then compute each component separately (quick assets, shareholders' funds, capital employed, cost of revenue, averages).

4. When a ratio and one figure are given, use the ratio as an equation to find the other figure.

5. For the effect of a transaction, write the before and after numerator and denominator.

6. State the ratio in its proper form: ": 1", "times" or "%".

Connections that matter

• Share capital and debentures give the shareholders' funds and long-term debt used in solvency ratios.

• Cash flow statement is the fourth tool of analysis, focusing on cash rather than profit.

• Class 11 final accounts taught gross and net profit; here they become ratios that can be compared across firms.

Common mistakes

• Including inventory or prepaid expenses in quick assets.

• Dividing a percentage change by the current year's figure. Always use the previous year.

• Using total revenue for trade receivables turnover. Use credit revenue.

• Using revenue instead of cost of revenue for inventory turnover.

• Using profit after tax for interest coverage or ROI. Both use profit before interest and tax.

• Classifying bank overdraft as long-term or calls in advance as share capital. Both are current liabilities.

• Assuming every equal change leaves a ratio unchanged. It does only when the ratio is exactly 1.

Revision checklist

• I can lay out a Schedule III balance sheet and classify the common items.

• I can state the objectives and limitations of analysis.

• I can prepare comparative and common-size statements.

• I can calculate all four groups of ratios with correct components.

• I can find a missing figure from a given ratio.

• I can explain the effect of a transaction on a ratio.