Basis of Comparison	Horizontal Analysis	Vertical Analysis
Meaning	It is the comparative evaluation of a financial statement of two or more periods, for calculating relative and absolute variances for every line of item	It is the analysis of financial data which is independent of time and items relating to financial information of company and its impact on the performance of the company.
Purpose	To specify changes in financial performance between two comparable accounting periods	To compare a financial item as a percentage of base figure
Comparison of	Intra-firm comparison	Both intra and inter firm comparison
Usefulness	Growth or decline of an item is represented here	Is useful in predicting and determining the relative proportion of an item of the financial statement to a common item in the financial statement

Question - 3 : - State the meaning of Analysis and Interpretation.

Answer - 3 : -

It is a critical and systematic examination of the financial statement. It presents the financial data in a systematic manner and also establishes a cause and effect relationship with all the items of financial statements. Analysis and interpretation is all about presenting financial data which is self-explanatory and easy to understand. It helps users of accounting information in assessing the status of financial performance of the business for a time period and enables them to take proper decision regarding finance policy of the firm.

Question - 4 : - State the importance of Financial Analysis?

Answer - 4 : -

Financial analysis is of great importance for the various users of accounting information. Financial statements such as Balance Sheets, Income sheets and other sources of financial data provide ample information on the various expenses and sources of profit, loss and income which is helpful in determining the financial status of a business. Financial data is not making any meaningful contribution until it is analysed. There are various methods which help in analysing financial statement and make it useful for various accounting users.

Following reasons are essential for performing financial analysis:

1. It is very helpful in determining the financial viability and profit earning capacity of the firm.

2. It is helpful in evaluating the business solvency in the long term

3. It is useful in comparing the financial status of a firm in comparison to other competitor firms

4. It helps management in decision making, drafting plan and also establish a robust and effective control mechanism

Question - 5 : - What are Comparative Financial Statements?

Answer - 5 : -

Comparative financial statements refer to statements which enable comparison that is both intra and inter firm and is based over a period of time. These statements help various users of accounting information in evaluating financial progress of a firm in relative terms. These statements express the data in absolute figures or as percentage change and absolute change that occurs in the item of the financial statement over a period of time. The data presented in financial statements are self-explanatory and easy to understand. When items of the financial statement are treated with the same accounting policies and practices over a fixed period of time, then the comparative data derived from such statements bear meaningful comparisons.

Two common types are:

1. Comparative Income Statement

2. Comparative Balance Sheet

Question - 6 : - What do you mean by Common Size Statements?

Answer - 6 : -

Common Size Statements are those statements where the items are displayed as percentages of a common base figure instead of absolute figures. It is helpful for proper analysis between companies (inter-firm comparison) or between time periods of the same company (intra-firm comparison). In these statements the relationship between items present in financial statements and common items like balance sheet total and net sales are highlighted in percentage. The analysis based on these statements is called as Vertical Analysis.

Two types are:

1. Common Size Income Statements

2. Common Size Balance Sheet

Question - 7 : - Describe the different techniques of financial analysis and explain the limitations of financial analysis.

Answer - 7 : -

Following different techniques are used for financial analysis:

1. Cash Flow Analysis: This analysis focuses on the inflow and outflow of cash and cash equivalents from the various activities of a business namely, investing, operating and financing activities during an accounting period. This helps in analysing cash payments and reason of receipt and the respective changes in cash balances during the accounting year.

2. Ratio Analysis: This method highlights the relationship between items of Balance Sheet and Income Statements. It is helpful in determining efficiency, profitability and solvency of a firm. This analysis expresses the financial items as fraction, percentage or proportion. Also, it determines the qualitative relationship among different financial variables. It also serves as a source of information regarding the performance, viability and financial position of a firm.

3. Trend Analysis: This technique studies the trends in operating performance and financial position of the business over a period of many years in succession. In such study, any particular year is considered as base year and the rest years are expressed as percentage of the base year’s figures. It helps in identifying problems and inefficiency along with detecting operating efficiency and financial position of the firm.

4. Comparative Statements: These statements use figures from two accounting periods that helps determine financial position and profitability. It also enables to do intra and inter firm comparison and therefore determine the efficiency of firm in relative terms. It uses both percentage as well as absolute terms. This analysis is known as Horizontal analysis.

5. Common size Statements: Common Size Statements are those statements where the items are displayed as percentages of a common base figure instead of absolute figures. It is helpful for proper analysis between companies (inter-firm comparison) or between time periods of the same company (intra-firm comparison). In these statements the relationship between items present in financial statements and common items like balance sheet total and net sales are highlighted in percentage. The analysis based on these statements is called as Vertical Analysis.

It has following limitations:

1. It fails to depict changes in accounting policy and procedures

2. These statements provide the interim report and hence have incomplete information.

3. These statements lack the qualitative aspect like growth prospects, managerial efficiency and express only in monetary terms

4. Financial analysis is based on accounting concepts and conventions and hence are not reliable as it does not take the current market value of items.

5. It involves personal biasness and judgements of the accountant for example in case of depreciation different methods can be charged for same item.

6. It does not take into account the change in price level. Only nominal values are considered.

Question - 8 : - Explain the usefulness of trend percentages in interpretation of financial performance of a company.

Answer - 8 : -

Trend analysis is a form of analysing financial data and it is expressed as percentage for each year. It helps the accounting user in evaluating financial performance of the business and also form opinion of various tendencies by which businesses can predict future trends.

Importance of trend analysis:

1. Predicting of the trends of business which is forecasting of future trends in business.

2. Trends are expressed as percentages which is less time consuming and easy to follow.

3. It becomes a popular financial analysis method due to trends being expressed in percentages which makes evaluating financial performance and operating efficiency of the firm relatively simpler.

4. It presents a broader picture of the performance of company in terms of finance, viability and efficiency.

Question - 9 : - What is the importance of comparative statements? Illustrate your answer with particular reference to comparative income statement.

Answer - 9 : -

Comparative statements have the following importance:

1. It presents financial data in a simple form, with year wise data being presented in side by side fashion making the presentation neat and enabling intra and inter-firm comparisons more conclusive.

2. Presentation is very effective for drawing insights quickly and easily

3. It assists the management in drafting future plans and forecast trends which is acheived by analysing profitability and operating efficiency of a business over time.

4. Comparative analysis helps easy detection of problems. Early detection helps take corrective measures and align the business in meeting the desired target.

Question - 10 : - What do you understand by analysis and interpretation of financial statements? Discuss its importance.

Answer - 10 : -

Following reasons are essential for performing financial analysis:

1. It is very helpful in determining the financial viability and profit earning capacity of the firm.

2. It is helpful in evaluating the solvency of the business in the long term

3. It is useful in comparing the financial status of a firm in comparison to other competitor firms

4. It helps management in decision making, drafting plan and also in establishing a robust and effective control mechanism

Free - Previous Years Question Papers

Chapter 4 Analysis of Financial Statements Solutions

Subscribe Now!