Key Takeaways:
- Learn the practical methods for analyzing financial statements: trend, comparative, and common-size analysis.
- Understand how to interpret changes in a firm's performance over time and compare financials between periods.
- Apply analysis techniques, including step-by-step conversion of a balance sheet into common-size format.
Source: Pixabay
Let's break down the core techniques: Trend Analysis, Comparative Statements, and Common-size (Vertical) Analysis.
Trend Analysis
a. Percentage Method
Trend analysis lets us observe how key financial metrics like sales, expenses, assets, or liabilities which change over time. Rather than just glancing at raw figures, we calculate the percentage increase or decrease for each item year-on-year. This method provides clarity about growth rates and highlights emerging patterns.
Formula:
Percentage change = [(Current Year Value - Previous Year Value) / Previous Year Value] × 100
Let's say sales were ₹10 lakh last year and ₹12 lakh this year. The percentage increase is [(12,00,000 - 10,00,000) / 10,00,000] × 100 = 20%.
b. Index Numbers for Several Years
Using index numbers, we set a base year (often the earliest year under review) and express subsequent years as an index relative to this base. The base year is always 100, and other years show proportional change.
Formula:
Index for Year = (Current Year Value / Base Year Value) × 100
If sales in 2021 (base year) are ₹8 lakh, and sales in 2023 are ₹12 lakh, the index number for 2023 is (12,00,000 / 8,00,000) × 100 = 150. This means sales grew by 50% since the base year.
Trend analysis answers questions such as:
1. Are sales growing steadily?
2. Are expenses rising faster than revenue?
3. These insights guide business strategy and investment decisions.
Comparative Statements
a. Comparing Two Years’ Financials
Comparative statements present figures for two (or more) periods side-by-side, making trends and changes instantly visible. Both absolute and percentage changes are shown, so you can see not just how much a figure changed, but how significant that change is relative to the starting amount.
| Item | Year 1 (₹) | Year 2 (₹) | Absolute Change (₹) | Percentage Change (%) |
|---|---|---|---|---|
| Sales | 10,00,000 | 12,00,000 | 2,00,000 | 20 |
| Cost of Goods Sold | 7,00,000 | 8,40,000 | 1,40,000 | 20 |
| Net Profit | 1,00,000 | 1,20,000 | 20,000 | 20 |
This approach helps you pinpoint exactly which areas have improved and which need attention. It's indispensable for year-on-year performance reviews and for answering exam questions that require direct comparison between periods.
Common-Size Statements
a. Express as Percentage of Sales or Total Assets
Common-size (vertical) analysis transforms each item in a financial statement into a percentage of a key figure total sales for the income statement, total assets for the balance sheet. This method standardizes the data, making it easy to compare companies of different sizes or to track structural changes in a single firm over time.
On the income statement, every item (costs, profits, etc.) is expressed as a percentage of sales. On the balance sheet, assets, liabilities, and equity are expressed as percentages of total assets.
Example:
Consider the following sample balance sheet for ABC Ltd. (figures in ₹ '000):
| Liabilities & Equity | Amount (₹ '000) |
|---|---|
| Equity Share Capital | 500 |
| Reserves & Surplus | 200 |
| Long-Term Debt | 300 |
| Current Liabilities | 100 |
| Total | 1,100 |
| Assets | Amount (₹ '000) |
|---|---|
| Fixed Assets | 600 |
| Investments | 100 |
| Current Assets | 400 |
| Total | 1,100 |
To create the common-size balance sheet, calculate each item as a percentage of total assets (₹1,100 '000):
| Liabilities & Equity | Amount (₹ '000) | % of Total Assets |
|---|---|---|
| Equity Share Capital | 500 | 45.45 |
| Reserves & Surplus | 200 | 18.18 |
| Long-Term Debt | 300 | 27.27 |
| Current Liabilities | 100 | 9.09 |
| Total | 1,100 | 100 |
| Assets | Amount (₹ '000) | % of Total Assets |
|---|---|---|
| Fixed Assets | 600 | 54.55 |
| Investments | 100 | 9.09 |
| Current Assets | 400 | 36.36 |
| Total | 1,100 | 100 |
By seeing the percentages, you're able to quickly assess the firm's capital structure and asset allocation.
Is the company heavily reliant on debt?
Are current assets sufficient?
Common-size analysis makes these questions easy to answer.
Trend, Comparative, and Common-size analyses are very foundational tools for evaluating business health.