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

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

Long Answer

Medium difficulty • Structured explanation

Medium

Question 1

Long Form

Describe the five tools of financial statement analysis, clearly distinguishing between horizontal and vertical analysis.

Comparative Statements (horizontal analysis) show financial position for two or more periods with absolute and percentage changes, helping identify trends in performance over time.
Common Size Statements (vertical analysis) express each item as a percentage of a common base within the same period — revenue from operations for P&L and total assets for the balance sheet.
Trend Analysis calculates trend percentages relative to a base year, enabling a long-run view that can reveal basic changes in the nature of the business and management quality.
Ratio Analysis describes significant relationships between items of the balance sheet and statement of profit and loss to assess profitability, solvency, and efficiency.
Cash Flow Analysis examines actual cash inflows and outflows during an accounting year, summarising causes for changes in the cash position between two balance sheet dates.

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Long Answer

Medium difficulty • Structured explanation

Medium

Question 2

Long Form

Analyse the significance of financial statement analysis for different categories of users, explaining how their interests differ.

Finance managers use financial analysis to assess managerial performance, corporate efficiency, creditworthiness, and to exercise financial control by reviewing deviations from expected results.
Top management uses it to ensure efficient use of resources, measure operational success, appraise individual performance, and evaluate the internal control system.
Trade payables focus on the firm's liquidity position and ability to meet short-term obligations; lenders focus on long-term solvency, cash generation, and capital structure.
Investors concentrate on present and future profitability and capital structure to assess earning potential and risk, and use analysis to decide whether to buy, sell, or hold shares.
Labour unions assess whether the firm can afford wage increases; economists and government agencies use it for understanding economic conditions, price regulation, and taxation decisions.

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Long Answer

Hard difficulty • Structured explanation

Hard

Question 3

Long Form

Compare comparative statements and common size statements in terms of their purpose, method of preparation, and usefulness in decision-making.

Comparative statements show absolute and percentage changes in financial data across two periods; common size statements express each item as a percentage of a common base within a period.
Comparative statements are prepared by listing figures for two years, computing absolute change (Year 2 minus Year 1), and then the percentage change relative to Year 1.
Common size statements are prepared by assigning 100 to a base (revenue from operations or total assets) and expressing all other items as percentages of that base.
Comparative statements are most useful for identifying trends, direction of change, and growth rates in performance indicators over time (time series / horizontal analysis).
Common size statements are most useful for inter-firm comparison across companies of different sizes or for understanding the structural composition of financials in a single period (vertical analysis).

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Long Answer

Medium difficulty • Structured explanation

Medium

Question 4

Long Form

Explain the objectives of financial statement analysis. How does the analysis serve the purpose of economists and government agencies?

The broad objective is to apprehend information in financial statements to know the firm's strengths and weaknesses and forecast its future prospects to enable better decisions.
Specific objectives include: assessing current profitability and operational efficiency, ascertaining the relative importance of different financial components, and identifying reasons for changes in profitability.
Another objective is to judge the firm's ability to repay debt and assess both short-term and long-term liquidity positions.
Economists analyse financial statements of various firms to judge the extent of concentration of economic power and identify pitfalls in financial policies pursued in the economy.
Government agencies use the analysis as the basis for actions relating to licensing, price controls, ceiling on profits, dividend freeze, tax subsidy, and other concessions to the corporate sector.

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Long Answer

Hard difficulty • Structured explanation

Hard

Question 5

Long Form

Critically examine the limitations of financial analysis, explaining why an analyst must exercise caution when interpreting financial statements.

Financial analysis does not consider price level changes — comparisons between periods can be distorted in times of inflation since historical cost figures are used.
Analysis may be misleading without knowledge of changes in the accounting procedure followed by a firm, as a change in method (e.g., depreciation) changes reported figures without real operational change.
Financial analysis is just a study of reported figures and is limited to monetary information, completely ignoring non-monetary aspects such as quality of management, employee morale, or brand value.
Financial statements are prepared on accounting concepts and conventions, so they do not reflect the current or fair value position of the firm, limiting the relevance of the analysis.
Analysts must also be conscious of window dressing — deliberate manipulation of financial statements by management — and personal judgement in valuations, both of which can distort the true picture.

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Long Answer

Medium difficulty • Structured explanation

Medium

Question 6

Long Form

Explain the concept of Trend Analysis. How does it help in detecting problems or signs of good management in a business enterprise?

Trend Analysis is a technique of studying operational results and financial position over a series of years using the previous years' data of a business enterprise.
The trend percentage is the percentage relationship in which each item of different years bears to the same item in the base year, making it easy to observe changes over time.
By looking at a trend in a particular ratio, one may find whether the ratio is falling, rising, or remaining relatively constant over the years.
From this observation, a problem may be detected — for example, a consistently falling gross profit ratio may signal deteriorating cost control or pricing issues.
Conversely, improving trends indicate signs of good management; the long-run view of trend analysis may also point to basic changes in the nature of the business itself.

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Long Answer

Medium difficulty • Structured explanation

Medium

Question 7

Long Form

Explain how common size statements are prepared for the statement of profit and loss and the balance sheet, giving the procedure step by step.

For both statements, the first step is to list out absolute figures in rupees at two points of time — Year 1 and Year 2 — in separate columns.
A common base is then chosen and assigned the value of 100: for the statement of profit and loss, revenue from operations is the base; for the balance sheet, total assets (or total liabilities) is the base.
For each item in Year 1 and Year 2, the percentage is calculated as (Item Amount / Common Base Amount) × 100 and recorded in the percentage columns.
In a common size P&L, all income and expense items are expressed as a percentage of revenue from operations, showing the proportion each item bears to total revenue.
In a common size balance sheet, each asset is expressed as a percentage of total assets, and each liability/equity item as a percentage of total liabilities, making structural comparison easy.

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Long Answer

Hard difficulty • Structured explanation

Hard

Question 8

Long Form

Explain what financial statement analysis involves and why it is considered both a science and an art involving judgement.

Financial statement analysis is the critical evaluation of financial information in financial statements to understand and make decisions regarding operations; it involves regrouping and analysing data to establish relationships.
It identifies strengths and weaknesses and throws light on points that can be useful in decision-making involving comparison with other firms (cross sectional) and with the firm's own performance over time (time series).
As a science, it uses systematic tools and quantitative techniques (comparative statements, ratios, trend percentages) that follow defined procedures.
As a judgemental art, it aims to estimate current and past positions with the primary objective of determining the best possible predictions about the future, requiring qualitative assessment.
The analyst must interpret the relationships and patterns identified by the tools in light of industry conditions, economic environment, and the firm's unique context — something that requires experience and judgement beyond mechanical calculation.

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Long Answer

Medium difficulty • Structured explanation

Medium

Question 9

Long Form

Explain the steps involved in preparing a comparative balance sheet and a comparative statement of profit and loss. Why must the same accounting principles be used?

For both, Step 1 involves listing absolute figures in rupees for the first year and second year in separate columns.
Step 2 involves computing the absolute change by subtracting the first year figure from the second year figure and marking each change as increase (+) or decrease (–).
Step 3 involves calculating the percentage change: (Absolute Change / First Year Figure) × 100, which facilitates comparison of magnitude independent of the scale of the item.
The same accounting principles must be used in both years because financial data will be truly comparative only when it is prepared on a consistent basis — different methods produce different figures for the same transaction.
If accounting principles differ between years, the deviation must be mentioned as a footnote so that users are aware and do not draw misleading conclusions from the comparison.

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Long Answer

Hard difficulty • Structured explanation

Hard

Question 10

Long Form

Distinguish between intra-firm comparison and inter-firm comparison. Explain which tool is most suitable for each and why.

Intra-firm comparison involves comparing a firm's own financial performance across different time periods — also called time series analysis.
Inter-firm comparison involves comparing the financial performance of two or more different companies, usually in the same industry — also called cross sectional analysis.
Comparative statements (horizontal analysis) are particularly suited to intra-firm comparison as they directly show changes in absolute and percentage terms between two periods for the same firm.
Common size statements (vertical analysis) are most suited to inter-firm comparison because they convert all figures to a common percentage base, eliminating size differences between companies.
Common size statements can also be used for intra-firm comparison over years, while comparative statements are generally less useful for inter-firm comparison because they involve absolute figures that differ between firms.

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

Describe the five tools of financial statement analysis, clearly distinguishing between horizontal and vertical analysis.

Analyse the significance of financial statement analysis for different categories of users, explaining how their interests differ.

Compare comparative statements and common size statements in terms of their purpose, method of preparation, and usefulness in decision-making.

Explain the objectives of financial statement analysis. How does the analysis serve the purpose of economists and government agencies?

Critically examine the limitations of financial analysis, explaining why an analyst must exercise caution when interpreting financial statements.

Explain the concept of Trend Analysis. How does it help in detecting problems or signs of good management in a business enterprise?

Explain how common size statements are prepared for the statement of profit and loss and the balance sheet, giving the procedure step by step.

Explain what financial statement analysis involves and why it is considered both a science and an art involving judgement.

Explain the steps involved in preparing a comparative balance sheet and a comparative statement of profit and loss. Why must the same accounting principles be used?

Distinguish between intra-firm comparison and inter-firm comparison. Explain which tool is most suitable for each and why.

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