Chapter analysis-of-financial-statements: Analysis of Financial Statements Application Questions | accountancy Class 12 CBSE

Chapter analysis-of-financial-statements: Analysis of Financial Statements Application Questions | accountancy Class 12 CBSE | ByteNotes.in

Application Question

Medium difficulty • Concept in a practical situation

Medium

Question 1

Applied Concept

A finance manager of ABC Ltd. notices that the company's revenue from operations increased by 25% but profit after tax increased by only 10% compared to the previous year. Which tool of financial analysis would most effectively help him investigate this discrepancy, and how would he use it?

The comparative statement of profit and loss would be the most effective tool, as it shows absolute and percentage changes in all income and expense items between the two years, enabling the finance manager to pinpoint which expense has grown disproportionately relative to revenue.
By examining the absolute and percentage increase in each expense head (e.g., employee benefit expenses, other expenses, depreciation, tax), the manager can identify whether a specific cost has risen faster than revenue — for example, a 60% increase in employee costs against a 25% revenue increase would explain the profit squeeze.
This comparative analysis directly serves the objective of identifying the reasons for change in the profitability of the firm, and enables the finance manager to take corrective action in financial control wherever indicated.

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Application Question

Medium difficulty • Concept in a practical situation

Medium

Question 2

Applied Concept

Sunita is a bank loan officer evaluating a loan application from two companies — Company X with total assets of Rs. 50 lakh and Company Y with total assets of Rs. 500 lakh — both in the same industry. She wants to compare their financial structures. Which tool should she use and why?

Sunita should use the common size balance sheet because it expresses each item as a percentage of total assets (the common base), eliminating the effect of the absolute size difference between the two companies.
Since Company X is ten times smaller than Company Y in absolute terms, direct comparison of rupee figures would be meaningless; the common size statement brings both companies to a common base of 100, allowing apples-to-apples structural comparison.
Common size analysis is specifically designed for inter-firm comparisons of companies that differ substantially in size, and allows Sunita to compare financing patterns (debt vs. equity proportion) and asset composition between the two companies to assess their relative financial structures.

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Application Question

Medium difficulty • Concept in a practical situation

Medium

Question 3

Applied Concept

With reference to the objectives of financial statement analysis, explain how a creditor (trade payable) would use financial analysis differently from an investor when evaluating the same company.

A trade payable is primarily interested in the firm's short-term liquidity — specifically, whether the company can meet its obligations within a very short period of time. Their analysis therefore focuses on current assets versus current liabilities and the firm's liquidity position.
An investor, in contrast, is interested in the company's present and future profitability and its capital structure, assessing how earnings and risk are likely to affect the value of shares. They also evaluate management efficiency to decide whether to buy, sell, or hold shares.
Thus, while both use the same financial statements, the trade payable asks 'Can the firm pay me soon?' while the investor asks 'Will this firm grow profitably and reward my investment?' — reflecting fundamentally different objectives that lead to different aspects of the analysis being emphasised.

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Application Question

Medium difficulty • Concept in a practical situation

Medium

Question 4

Applied Concept

A student preparing the comparative statement of profit and loss of Madhu Co. Ltd. finds that 'other expenses' decreased from Rs. 2,00,000 to Rs. 1,00,000 between 2015-16 and 2016-17. How should this change be recorded, and what does a negative percentage change indicate?

The absolute change should be recorded as Rs. (1,00,000) — i.e., a decrease of Rs. 1,00,000 — shown in brackets or with a minus sign in Column 4 of the comparative statement to indicate a decrease.
The percentage change should be recorded as (50)% — calculated as (–1,00,000 / 2,00,000) × 100 = –50% — shown in brackets to indicate a decrease of 50%.
A negative percentage change in expenses indicates a favourable trend from the firm's perspective — other expenses have been reduced by half, which directly contributes to an improvement in profit before tax, all else being equal.

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Application Question

Hard difficulty • Concept in a practical situation

Hard

Question 5

Applied Concept

In a common size statement of profit and loss for BCR Ltd., the employee benefit expenses as a percentage of revenue from operations increased from 33% in Year 1 to 50% in Year 2. What conclusion can be drawn, and what action might the management take?

The increase in employee benefit expenses as a percentage of revenue from operations from 33% to 50% indicates that personnel costs are rising faster than revenue, significantly eroding the firm's profitability margin.
This could be due to factors such as salary increments, increased headcount, new benefit schemes, or declining revenue — all of which the management needs to investigate. The common size percentage change directly highlights this structural shift.
Management may need to consider cost rationalisation measures such as workforce optimisation, automation, or productivity-linked pay structures, or alternatively focus on revenue growth strategies to restore the expense-to-revenue ratio to acceptable levels.

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Application Question

Hard difficulty • Concept in a practical situation

Hard

Question 6

Applied Concept

Rajan, a research analyst, is comparing two companies — A (manufacturing) and B (services) — to recommend one for investment. Both are in different industries. Can he use inter-firm comparison effectively? What limitation should he be aware of?

Inter-firm comparison is most effective when comparing companies in the same industry; comparing a manufacturing firm with a services firm using the same financial parameters can be misleading because industry norms, cost structures, and asset compositions differ significantly.
For example, a manufacturing firm will naturally have a higher proportion of fixed assets and inventories, while a services firm will have fewer tangible assets — this does not mean one is better managed than the other; it simply reflects different business models.
Rajan should therefore be cautious about drawing conclusions purely from common size percentages across different industries, and must supplement the quantitative analysis with qualitative knowledge of each industry's norms, thereby acknowledging that financial analysis is a judgemental process rather than a purely mechanical one.

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Application Question

Hard difficulty • Concept in a practical situation

Hard

Question 7

Applied Concept

With reference to the preparation of comparative statements, explain what would happen to the percentage change calculation if the first year's figure for an item is zero. Why is this a practical limitation?

If the first year's absolute figure is zero, the percentage change formula — (Absolute Change / First Year Figure) × 100 — would involve division by zero, which is mathematically undefined and therefore cannot be calculated.
This is a practical limitation of comparative statements when a new item appears in the second year (such as a new liability being created or a new type of income being earned) because the percentage change is not computable.
In practice, the analyst must either leave the percentage change column blank for that item or note it separately, ensuring that users of the comparative statement are not misled about the nature and magnitude of the change.

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Application Question

Medium difficulty • Concept in a practical situation

Medium

Question 8

Applied Concept

A labour union is in wage negotiation with the management of XYZ Ltd. The management claims it cannot afford a wage increase. How would the union use financial statement analysis to evaluate this claim?

The labour union would analyse the company's statement of profit and loss to assess the current profitability — specifically, whether the profit after tax is substantial and growing, which would contradict the management's claim of inability to afford a wage increase.
The union would also examine whether the firm can absorb a wage increase through increased productivity (i.e., whether output per employee is rising) or by marginally raising prices, both of which are indicators of the firm's wage absorption capacity.
If the comparative statement shows a rising trend in profits and the common size statement shows that employee benefit expenses as a percentage of revenue have declined over the years, the union would have strong analytical grounds to challenge management's claim and negotiate a wage increase.

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Application Question

Medium difficulty • Concept in a practical situation

Medium

Question 9

Applied Concept

During the preparation of a comparative balance sheet, a student observes that the reserve and surplus of J. Ltd. decreased from Rs. 4,00,000 to Rs. 3,00,000 between 2016 and 2017. How should this be presented and what might it indicate?

The absolute change should be shown as Rs. (1,00,000) — a decrease of Rs. 1,00,000 — in brackets in the absolute change column, and the percentage change as (25)% — calculated as (–1,00,000 / 4,00,000) × 100 = –25%.
A decrease in reserves and surplus could indicate that the company incurred a net loss during the year, paid dividends in excess of earnings, or utilised reserves for capital redemption or other purposes.
This is generally an unfavourable signal because declining reserves reduce the firm's internal financial cushion, increase dependence on external financing, and may signal deteriorating profitability or aggressive dividend policies.

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Application Question

Hard difficulty • Concept in a practical situation

Hard

Question 10

Applied Concept

Priya is comparing a common size balance sheet of XRI Ltd. for two years and notices that the percentage of trade payables to total assets decreased from 37.35% to 32.31%. What does this indicate, and is it favourable?

A decrease in trade payables as a percentage of total assets from 37.35% to 32.31% indicates that the firm's reliance on short-term credit from suppliers has reduced relative to its total asset base.
This is generally a favourable indicator as it suggests improved payment discipline, reduced short-term financial risk, or a strengthening of the firm's liquidity and working capital management.
However, the analyst should also check whether this decrease is due to actual repayment of creditors (favourable) or due to a reduction in purchases (which could indicate declining business activity), as the interpretation depends on the context of other figures in the common size statement.

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Chapter analysis-of-financial-statements: Analysis of Financial Statements | Application Questions

A finance manager of ABC Ltd. notices that the company's revenue from operations increased by 25% but profit after tax increased by only 10% compared to the previous year. Which tool of financial analysis would most effectively help him investigate this discrepancy, and how would he use it?

Sunita is a bank loan officer evaluating a loan application from two companies — Company X with total assets of Rs. 50 lakh and Company Y with total assets of Rs. 500 lakh — both in the same industry. She wants to compare their financial structures. Which tool should she use and why?

With reference to the objectives of financial statement analysis, explain how a creditor (trade payable) would use financial analysis differently from an investor when evaluating the same company.

A student preparing the comparative statement of profit and loss of Madhu Co. Ltd. finds that 'other expenses' decreased from Rs. 2,00,000 to Rs. 1,00,000 between 2015-16 and 2016-17. How should this change be recorded, and what does a negative percentage change indicate?

In a common size statement of profit and loss for BCR Ltd., the employee benefit expenses as a percentage of revenue from operations increased from 33% in Year 1 to 50% in Year 2. What conclusion can be drawn, and what action might the management take?

Rajan, a research analyst, is comparing two companies — A (manufacturing) and B (services) — to recommend one for investment. Both are in different industries. Can he use inter-firm comparison effectively? What limitation should he be aware of?

With reference to the preparation of comparative statements, explain what would happen to the percentage change calculation if the first year's figure for an item is zero. Why is this a practical limitation?

A labour union is in wage negotiation with the management of XYZ Ltd. The management claims it cannot afford a wage increase. How would the union use financial statement analysis to evaluate this claim?

During the preparation of a comparative balance sheet, a student observes that the reserve and surplus of J. Ltd. decreased from Rs. 4,00,000 to Rs. 3,00,000 between 2016 and 2017. How should this be presented and what might it indicate?

Priya is comparing a common size balance sheet of XRI Ltd. for two years and notices that the percentage of trade payables to total assets decreased from 37.35% to 32.31%. What does this indicate, and is it favourable?

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