A

REPORT

On

“Financial Statements Analysis”

Submitted in partial

Fulfilment for the award of the

degree of

Bachelor of Technology in Department of Civil Engineering

Submitted to: Submitted by:

Mr. Rohit Soni Lalit Kishor Soni

HOD, Civil Department 23E1SBCEM30P005

Department of Civil Engineering

Sri Balaji College of Engineering and Technology, Jaipur

Rajasthan Technical University, Kota

May, 2025
 CANDIDATE’S DECLARATION

I hereby declare that the report work entitled “Financial Statements Analysis” submitted to
the Sri Balaji Collage of Engineering and Technology, Jaipur, Rajasthan Technical University,
Kota is a record of original work done by me under the guidance of Mr. Rohit Soni,
Department of Civil Engineering, Sri Balaji College of Engineering & Technology, Jaipur.

Lalit Kishor Soni

Civil Engineering

23E1SBCEM30P005

Sri Balaji College of Engineering & Technology

Counter Signed By:

Mr. Zubbair Khan

Assistant Professor

Department of Civil Engineering

Sri Balaji College of Engineering & Technology

i
 ACKNOWLEDGEMENT

I want to thank everyone who has helped and supported me throughout my report. First and
foremost, a big thank you to my professor, Mr. Rohit Soni, for giving me valuable guidance
and pointing me in the right direction. I am also grateful to our wonderful principal, who has
created a nurturing and creative environment in our college. I would also like to acknowledge
my parents and my friends, who encouraged me and contributed their ideas and perspectives,
which greatly enriched the report.

Lalit Kishor Soni

Civil Engineering

23E1SBCEM30P005

Sri Balaji College of Engineering & Technology

ii
 TABLE OF CONTENTS

Title Page No.

Candidate’s Declaration i
Acknowledgement ii
Table Of Contents iii-v
List Of Table vi
Abstract 1
Chapter-1 Introduction to Financial Statements 2-6
1.1 Purpose and Importance of Financial Statements 2
1.2 Types of Financial Statements 3-4
1.3 Users of Financial Statements 4-5
1.4 Regulatory Framework and Standards 5-6
Chapter-2 Understanding the Profit & Loss Statement 7-10
2.1 Introduction to the Profit & Loss Statement 7
2.2 Structure of the P&L Statement 7-8
2.3 Types of P&L Statements 8
2.4 Importance of the P&L Statement 8-9
2.5 Key Metrics Derived from P&L 9
2.6 Limitations of the P&L Statement 10
2.7 Relationship with Other Financial Statements 10
Chapter 3 Understanding the Balance Sheet 11-14
3.1 Introduction to the Balance Sheet 11
3.2 Structure of the Balance Sheet 11-12
3.3 Importance of the Balance Sheet 12-13
3.4 Vertical & Horizontal Analysis 13
3.5. Limitations of the Balance Sheet 13-14
3.6 Balance Sheet and Business Strategy 14
3.7 Comparison Across Industries 14
Chapter-4 Understanding the Cash Flow Statement 15-17
4.1 Introduction to the Cash Flow Statement 15

iii
4.2 Components of the Cash Flow Statement 15-16
4.3 Importance of Cash Flow Statement 16-17
4.4 Cash vs. Profit 17
4.5 Key Cash Flow Ratios 17
Chapter-5 Financial Ratios and Their Interpretation 18-19
5.1 Introduction to Financial Ratios 18
5.2 Liquidity Ratios 18
5.3 Profitability Ratios 18
5.4 Market Valuation Ratios 19
5.5 DuPont Analysis 19
Chapter 6 Analysis of Financial Statements 20-22
6.1 Introduction to Financial Statement Analysis Techniques 20
6.2 Horizontal Analysis (Trend Analysis) 20
6.3 Vertical Analysis (Common-Size Analysis) 21
6.4 Benefits of Horizontal and Vertical Analysis 21
6.5 Limitations of These Methods 22
Chapter-7 Common-Sized Financial Statements 23-24
7.1 Introduction to Common-Sized Financial Statements 23
7.2 Purpose of Common-Sizing 23
7.3 Common-Sized Income Statement 23
7.4 Common-Sized Balance Sheet 23
7.5 Advantages of Common-Sized Statements 24
7.6 Application Areas 24
Chapter-8 Limitations of Financial Statement Analysis 25-28
8.1 Dependence on Historical Data 25
8.2 Accounting Policies and Estimates 25
8.3 Non-Financial Information is Ignored 25-26
8.4 Inflation and Currency Fluctuations 26
8.5 Window Dressing and Creative Accounting 26
8.6 Limited Predictive Power 27
8.7 Sector and Industry Differences 27

iv
8.8 Consolidation and Complexity 27
8.9 Real-World Implications 28
Conclusion 29-30
References 31

v
 LIST OFTABLE

Title page no.

Table2.1: Key metrics derived from the P&L 9

Table3.1: Balance Sheet Ratios 13
Table5.1: Liquidity Ratios 18
Table5.2: Profitability Ratios: 18
Table6.1: Ratios Derived from Vertical Analysis 22

vi
 ABSTRACT

This report presents a comprehensive overview of Financial Statement Analysis, an essential

discipline in evaluating a company’s financial health and performance. It spans eight chapters
covering foundational concepts, analytical tools, and real-world limitations of financial
reporting. The study begins with an introduction to key financial statements—Balance Sheet,
Income Statement, and Cash Flow Statement—and explains their roles in decision-making
for stakeholders such as investors, creditors, and management.

Subsequent chapters explore various analytical techniques, including horizontal and vertical
analysis, ratio analysis, and trend evaluation. These methods help interpret financial data,
reveal operational efficiency, assess solvency and liquidity, and track performance over time.
The report also discusses Comparative and Common-Sized Financial Statements, which
allow analysts to compare financial data across time periods and entities by normalizing
figures.

The final chapter addresses the limitations of financial analysis, such as reliance on historical
data, accounting policy discrepancies, and the exclusion of non-financial information.
Despite these limitations, when used correctly and in context, financial statement analysis
remains a powerful tool for strategic business decisions.

Keywords: Financial Statements, Ratio Analysis, Cash Flow, Trend Analysis, Horizontal
Analysis, Vertical Analysis, Common-Sized Statements, Comparative Statements, Liquidity,
Solvency, Profitability, Financial Reporting, IFRS, GAAP.

1
 Chapter-1

INTRODUCTION TO FINANCIAL STATEMENTS

1.1 Purpose and Importance of Financial Statements

Financial statements serve as the fundamental tools for communicating financial information
about a business to stakeholders. Their primary purpose is to provide a clear, accurate, and
comprehensive overview of an organization’s financial performance and position over a
specific period.

These statements play a vital role in:

 Decision Making: Investors, management, and other stakeholders use financial data to
make informed decisions regarding investments, resource allocation, expansion plans,
and operational adjustments.

 Performance Evaluation: Financial statements help assess a company’s past and

current financial performance, efficiency, profitability, and financial stability.

 Accountability and Transparency: They establish a framework for accountability

between management and stakeholders. Publicly traded companies are mandated to
disclose their financials, enhancing transparency and trust.

 Legal and Regulatory Compliance: Financial reporting is often required under various
laws and standards. Timely and accurate reporting helps avoid legal repercussions and
ensures regulatory compliance.

 Financial Planning and Budgeting: Historical financial data guide future business
strategies and budgeting processes.

Overall, financial statements are essential for maintaining financial discipline and enabling
sound economic decisions.

1.2 Types of Financial Statements

There are three primary types of financial statements, each offering unique insights into
different aspects of an organization’s financial health.

2
a. Profit and Loss Statement (P&L)

Also known as the Income Statement, the P&L statement shows the company’s revenues and
expenses during a particular period. The goal is to determine whether the business is making
a profit or incurring a loss.

Key Components:

 Revenue/Sales

 Cost of Goods Sold (COGS)

 Gross Profit

 Operating Expenses (e.g., salaries, rent)

 Operating Profit (EBIT)

 Net Profits

b. Balance Sheet

The Balance Sheet provides a snapshot of a company’s financial position at a specific point
in time. It outlines the company’s assets, liabilities, and shareholder equity.

Structure:

 Assets: Current (cash, receivables, inventory) and Non-current (property, equipment)

 Liabilities: Current (payables, short-term debt) and Long-term (loans, bonds)

 Equity: Shareholder capital, retained earnings

It follows the equation: Assets = Liabilities + Equity

This statement is crucial in understanding the liquidity, solvency, and capital structure of a
company.

c. Cash Flow Statement

The Cash Flow Statement tracks the flow of cash in and out of the business across three main
activities:

3
  Operating Activities: Cash generated from day-to-day business operations.

 Investing Activities: Cash used for investments in assets or securities.

 Financing Activities: Cash from issuing debt or equity, and paying dividends.

This statement is vital for assessing the liquidity position and cash management capabilities
of a business.

1.3 Users of Financial Statements

Various stakeholders use financial statements for diverse purposes. These users can be
broadly categorized into internal and external users:

a. Internal Users

 Management: Uses financial reports to make strategic decisions, set performance

targets, and manage operations.

 Employees: Review financial health for job security, salary negotiations, and
performance incentives.

b. External Users

 Investors and Shareholders: Evaluate profitability and growth prospects to make

investment decisions.

 Creditors and Lenders: Assess the company’s ability to repay loans and meet financial
obligations.

 Regulatory Authorities: Ensure compliance with financial reporting laws and

regulations.

 Suppliers and Trade Partners: Examine solvency to determine the risk of doing
business.

 Customers: Large clients may review financial strength to assess long-term business
viability.

4
  Analysts and Researchers: Analyze trends and performance for reports, publications,
and forecasting.

Each group depends on accurate, timely, and transparent financial data to make well-
informed decisions.

1.4 Regulatory Framework and Standards

Financial reporting must adhere to a structured set of standards and regulatory guidelines to
ensure consistency, comparability, and transparency.

a. Accounting Standards

 Generally Accepted Accounting Principles (GAAP): Widely used in the United States;
it provides a common set of rules and guidelines.

 International Financial Reporting Standards (IFRS): Used in over 140 countries

globally, IFRS aims at harmonizing financial reporting across borders.

 These standards define how transactions should be recorded, how financial elements
are recognized and measured, and how the results are presented.

b. Regulatory Bodies

 Securities and Exchange Commission (SEC) (US): Oversees financial reporting of

public companies.

 Financial Accounting Standards Board (FASB): Develops and updates GAAP.

 International Accounting Standards Board (IASB): Oversees the development of

IFRS.

 Institute of Chartered Accountants: In many countries, national accounting bodies

regulate and supervise reporting practices and professional conduct.

c. Auditing and Compliance

 Audits: Independent auditors examine financial statements to ensure they are free
from material misstatements and comply with applicable standards.

5
  Corporate Governance Requirements: Regulatory frameworks like SOX (Sarbanes-
Oxley Act) enforce internal control systems and managerial accountability.

Regulations ensure the integrity of financial information and protect stakeholder interests by
minimizing the risk of fraud and manipulation.

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 Chapter-2

UNDERSTANDING THE PROFIT & LOSS STATEMENT

2.1 Introduction to the Profit & Loss Statement

The Profit and Loss Statement (P&L), also referred to as the Income Statement, is one of the
core financial statements. It summarizes the revenues, costs, and expenses incurred during a
specific period, typically a fiscal quarter or year. The primary purpose is to measure a
company’s financial performance—specifically whether it generated a net profit or net loss.

Unlike the balance sheet (a snapshot), the P&L captures the flow of income and expenses
over time. It reflects how a company transforms revenues into net earnings and how
efficiently it manages its operations.

2.2 Structure of the P&L Statement

The P&L Statement is usually structured in a step-down format, starting with total revenue
and subtracting various categories of expenses until the bottom line (net profit or loss) is
reached. Main sections includes :-

1. Revenue / Sales

 Represents the total income from goods sold or services rendered.

 May be broken down into gross sales, returns, and net sales.

2. Cost of Goods Sold (COGS)

 Direct costs related to the production or delivery of goods/services.

 Includes raw materials, direct labor, and manufacturing overhead.

3. Gross Profit
Formula: Gross Profit = Revenue – COGS

4. Operating Expenses

 Costs not directly tied to production, including:

 Selling, General & Administrative (SG&A)

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  Salaries, rent, utilities

 Marketing and advertising

5. Operating Profit (EBIT)

 Earnings Before Interest and Taxes

 Formula: EBIT = Gross Profit – Operating Expenses

2.3 Types of P&L Statements

a. Single-Step Income Statement

 Summarizes all revenues and gains together, and all expenses and losses together.

 Simpler format; useful for small businesses.

b. Multi-Step Income Statement

 Separates operating and non-operating activities.

 Includes subtotals like Gross Profit, Operating Income, and Net Income.

 More detailed and preferred by analysts and investors.

2.4 Importance of the P&L Statement

The P&L provides crucial insights into a company’s:

i. Profitability

 Shows whether the business is operating at a profit or loss.

 Key metric: Net Profit Margin = (Net Income / Revenue) x 100

ii. Operational Efficiency

 Helps identify if operating expenses are controlled relative to revenue.

 High gross margins with low net margins can signal inefficiencies.

8
iii. Cost Management

 Breaks down costs to help management identify overspending.

 Enables strategic cost reduction and budgeting.

iv. Investment Decisions

 Investors analyze trends in earnings, margins, and growth.

 Strong, consistent profits increase valuation and investor confidence.

2.5 Key Metrics Derived from P&L

Several financial ratios and indicators are calculated from the P&L the table is following

1.Gross Profit Margin = (Gross Profit / Revenue) x 100Measures production

efficiency.
2.OperatingMargin = (EBIT / Revenue) x 100
3.Net Profit Margin = (Net Profit / Revenue) x 100

4.Earnings Per Share (EPS) = (Net Income – Preferred Dividends) / Weighted

Average Shares

Table 2.1 Key Metrics Derived from P&L

2.6 Limitations of the P&L Statement

While powerful, the P&L has its limitations:

1. Non-Cash Transactions

 Includes depreciation and amortization, which don’t affect actual cash.

2. manipulability

 Revenues can be inflated through aggressive accounting.

 Expenses can be deferred or capitalized inappropriately.

3. Does Not Reflect Cash Flow

 A company can show profits but still face cash shortages.

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4. One-Dimensional View

 Doesn’t reveal asset utilization, liquidity, or long-term solvency.

2.7 Relationship with Other Financial Statements

 P&L and Balance Sheet:

Net income from the P&L contributes to retained earnings under shareholders’ equity
on the balance sheet.

 P&L and Cash Flow Statement:

The starting point of the cash flow statement (indirect method) is net income from the
P&L.

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 Chapter-3

UNDERSTANDING THE BALANCE SHEET

3.1 Introduction to the Balance Sheet

The Balance Sheet, also known as the Statement of Financial Position, provides a snapshot of
a company’s financial standing at a specific point in time. It reveals what the company owns
(assets), what it owes (liabilities), and the residual interest (equity) held by its shareholders.

It is governed by the fundamental accounting equation:Assets = Liabilities + Equity

This equation ensures that the balance sheet always remains "balanced." The balance sheet
helps stakeholders evaluate the company’s financial structure, liquidity, solvency, and capital
efficiency.

3.2 Structure of the Balance Sheet

The balance sheet is broadly divided into three main sections:

1. Assets

Assets represent resources controlled by the company, expected to bring future economic
benefits. These are categorized as:

a. Current Assets (convertible to cash within one year)

 Cash & Cash Equivalents: Cash in hand, bank accounts, treasury bills.

 Accounts Receivable: Money owed by customers.

 Inventory: Raw materials, work-in-progress, and finished goods.

 Prepaid Expenses: Payments made for future services (e.g., insurance).

 Short-term Investments: Marketable securities held temporarily.

b. Non-Current Assets (long-term investments)

 Property, Plant & Equipment (PP&E): Land, buildings, machinery.

 Intangible Assets: Patents, goodwill, trademarks.

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  Long-term Investments: Equity investments, bonds.

 Deferred Tax Assets: Future tax reliefs from temporary timing differences.

2. Liabilities

Liabilities are financial obligations the company owes to external parties. They are also split
into:

a. Current Liabilities

 Accounts Payable: Dues to suppliers.

 Short-term Loans: Bank overdrafts, working capital loans.

 Accrued Expenses: Salaries, taxes payable.

 Unearned Revenue: Payments received before services are rendered.

b. Non-Current Liabilities

 Long-term Debt: Bonds, term loans.

 Lease Liabilities: Payable over multiple years.

 Deferred Tax Liabilities: Future tax obligations.

 Pension Liabilities: Long-term employee benefits.

3.3 Importance of the Balance Sheet

The balance sheet is an essential tool for:

a. Liquidity Analysis

 Can the company meet its short-term obligations?

 Key metric: Current Ratio = Current Assets / Current Liabilities

b. Solvency Assessment

 Does the company have a manageable debt load?

 Key metric: Debt-to-Equity Ratio = Total Liabilities / Equity

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c. Financial Stability

 Reveals capital structure: equity vs. debt financing.

 Stability indicates less risk during downturns.

d. Asset Utilization

 Determines whether assets are being used productively.

 Return on Assets (ROA) and Asset Turnover Ratios are derived here.

1. Current Ratio= Current Assets / Current Liabilities Measures liquidity position.

2. Quick Ratio (Acid-Test Ratio)= (Current Assets – Inventory) / Current Liabilities

3. Debt-to-Equity Ratio= Total Liabilities / Shareholders’ Equity Indicates financial
leverage and risk.
4. Return on Equity (ROE)= Net Income / Shareholders’ Equity
5. Working Capital= Current Assets – Current Liabilities
Table3.1: Balance Sheet Ratios

3.4 Vertical & Horizontal Analysis

Vertical Analysis:

 Express each item as a % of total assets or total liabilities/equity.

 Useful for comparing balance sheets across companies of different sizes.

Horizontal Analysis:

 Compares figures over multiple periods to detect growth trends.

 Helps identify asset accumulation, debt growth, or equity dilution.

3.5. Limitations of the Balance Sheet

1. Historical Cost Accounting:

 Assets are recorded at purchase cost, not market value.

 Doesn’t reflect current worth of assets like real estate or machinery.

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2. Static Nature:

 Reflects a single day’s data; may not show seasonal variations.

3. Omitted Intangible Assets:

 Self-developed goodwill or brand value is not reflected unless acquired.

4. Window Dressing:

 Companies may manipulate end-of-period numbers to appear healthier.

3.6 Balance Sheet and Business Strategy

The balance sheet is a reflection of how a company manages its resources:

 Capital Structure Decisions: Whether to raise funds through debt or equity.

 Investment in Assets: Shows the company’s commitment to growth or technology.

 Working Capital Management: Determines liquidity and operational efficiency.

Example: If a company has growing inventory and receivables but stagnant sales, it might
signal inefficient asset use or a demand slump—key insights derived directly from balance
sheet analysis.

3.7 Comparison Across Industries

Balance sheet norms vary across sectors:

 Manufacturing firms have higher fixed assets and inventories.

 IT or service companies may have minimal fixed assets but high intangibles.

 Retailers often have high current assets (stock) and quick turnovers.

Thus, analysis should be industry-specific and based on appropriate benchmarks.

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 Chapter-4

UNDERSTANDING THE CASH FLOW STATEMENT

4.1 Introduction to the Cash Flow Statement

The Cash Flow Statement (CFS) details the movement of cash and cash equivalents into and
out of a business over a period. Unlike the income statement, which includes non-cash items,
the CFS focuses strictly on liquidity—actual cash available for operations, investments, and
financing.

It provides critical insights into a company’s ability to:

 Pay its bills

 Fund operations

 Meet debt obligations

 Invest in growth

4.2 Components of the Cash Flow Statement

The CFS is divided into three main activities:

1. Operating Activities: Covers cash flow from core business operations.

a. Cash inflows:

 Receipts from customers

 Interest and dividends received

b. Cash outflows:

 Payments to suppliers and employees

 Income taxes

 Interest paid

c. Two approaches to present cash from operations:

15
  Direct Method: Shows actual cash receipts and payments.

 Indirect Method: Starts from net income and adjusts for non-cash transactions (most
common).

2. Investing Activities: Cash flows from buying or selling long-term assets.

a. Cash inflows:

 Sale of property, plant, or equipment

 Sale of investments

b. Cash outflows:

 Purchase of equipment

 Acquiring subsidiaries

 R&D capital expenditures

3. Financing Activities: Cash related to borrowing and equity transactions.

a. Cash inflows:

 Issuing shares

 Raising debt

b. Cash outflows:

 Loan repayments

 Dividend payments

 Share buybacks

4.3 Importance of Cash Flow Statement

The CFS provides clarity on:

1. Liquidity & Solvency

 Is there enough cash to meet short-term obligations?

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  Shows real-time financial flexibility.

2. Operational Health

 Even profitable companies can run into cash problems.

 Operating cash flow should ideally be positive and growing.

3. Investment Potential

 Strong cash flow supports growth initiatives, dividend payouts, and debt reduction.

4.4 Cash vs. Profit

Understanding the difference between cash and profit is crucial:

 Profit includes non-cash items like depreciation and amortization.

 Cash flow captures actual money movement, unaffected by accounting assumptions

Example: A company may report high profits but poor cash flow due to excessive credit sales
or large inventories.

4.5 Key Cash Flow Ratios

1. Operating Cash Flow Ratio= Operating Cash Flow / Current Liabilities

2. Free Cash Flow (FCF)= Operating Cash Flow – Capital Expenditures

3. Cash Conversion Cycle= Days Inventory + Days Receivable – Days Payable

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 Chapter-5

FINANCIAL RATIOS AND THEIR INTERPRETATION

5.1 Introduction to Financial Ratios: Financial ratios are quantitative tools used to evaluate
a company’s performance and financial condition. These ratios simplify complex financial
data, helping users interpret the relationships between different elements of the financial
statements.

5.2 Liquidity Ratios: These measure a company’s ability to meet short-term obligations.

a. Current Ratio= Current Assets / Current Liabilities Benchmark: >1 indicates good short-term
financial health.

b. Quick Ratio (Acid-Test)= (Current Assets – Inventory) / Current Liabilities

c. Cash Ratio= (Cash + Marketable Securities) / Current Liabilities

Table 5.1: Liquidity Ratios

5.3 Profitability Ratios: Indicate a company’s ability to generate profits relative to revenue.

Gross Profit Margin= Gross Profit / Revenue × 100

b. Net Profit Margin= Net Income / Revenue × 100

c. Return on Assets (ROA)= Net Income / Average Total Assets

d. Return on Equity (ROE)= Net Income / Average Shareholders’ Equity

Table 5.2: Profitability Ratios:

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5.4 Market Valuation Ratios

Used by investors to assess stock price and growth potential.

a. Earnings Per Share (EPS)= Net Income – Preferred Dividends / Weighted Avg. Shares
Shows portion of profit per share.

b. Price-to-Earnings (P/E) Ratio= Market Price per Share / Earnings Per Share
Indicates market expectation of earnings.

c. Dividend Yield= Dividend per Share / Market Price per Share

Measures return on investment from dividends.

d. Market-to-Book Ratio= Market Value of Equity / Book Value of Equity

Shows market perception vs. actual worth.

5.5 DuPont Analysis

1. Breaks down ROE into components:

ROE = Net Profit Margin × Asset Turnover × Equity Multiplier

This gives a deeper view into what drives return on equity—profitability, efficiency, or
leverage.

2. Limitations of Financial Ratios

 Accounting differences: Methods vary across firms and countries.

 Window dressing: Financials may be manipulated to look better temporarily.

 One-size-fits-all: Industry-specific standards may vary.

 Static nature: Based on historical data, may not reflect future performance.

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 Chapter-6

ANALYSIS OF FINANCIAL STATEMENTS

6.1 Introduction to Financial Statement Analysis Techniques

To make financial statements more insightful and comparable, two powerful techniques are
used:

 Horizontal Analysis (also known as trend analysis)

 Vertical Analysis (also known as common-size analysis)

These methods help identify trends, proportions, and significant changes over time or across
entities.

6.2 Horizontal Analysis (Trend Analysis)

Definition: Horizontal analysis evaluates financial performance over multiple periods. It

highlights absolute and percentage changes in key financial items.

Formulas-

1. Absolute Change = Current Year Amount – Base Year Amount

2. Percentage Change = (Absolute Change / Base Year Amount) × 100

Key Uses:

 Identify trends (growth/decline)

 Evaluate business cycles and seasonal effects

 Detect abnormalities or one-time events

Example: Horizontal Analysis of Income Statement

Interpretation:

 Consistent 30% growth in revenue and gross profit shows stable expansion.

 Net income has grown faster, indicating improved cost management.

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6.3 Vertical Analysis (Common-Size Analysis)

Definition :Vertical analysis represents each item in the financial statement as a percentage of
a base item.

 In Income Statement: Every line item is expressed as a % of Net Sales.

 In Balance Sheet: Each item is shown as a % of Total Assets or Total Liabilities +

Equity.

Formula: Common Size % = (Item Amount / Base Amount) × 100

Key Uses:

 Simplifies inter-company comparison regardless of size

 Identifies cost structure, margin patterns

 Assists in performance benchmarking

Example: Vertical Analysis of Income Statement

6.4 Benefits of Horizontal and Vertical Analysis

1. Horizontal Analysis

 Tracks growth trends

 Detects performance fluctuations

 Identifies seasonal changes or cyclical behaviour

2. Vertical Analysis

 Facilitates benchmarking across firms or industries

 Highlights cost structure and profitability proportions

 Essential in common-size reporting for investor presentations

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6.5 Limitations of These Methods

1. Horizontal Analysis:

 Not useful if company underwent restructuring or M&A

 Inflation may distort results

 Requires consistent accounting standards

2. Vertical Analysis:

 Does not reveal trends across periods

 May mask actual volume growth or decline

 Percentages can be misleading if absolute amounts are very small or large

3. Key Ratios Derived from Vertical Analysis

Gross Profit Margin = (Gross Profit / Sales) × 100

Operating Margin = (Operating Income / Sales) × 100

Net Profit Margin = (Net Income / Sales) × 100

Asset Composition Ratios (e.g., Inventory / Total Assets)

Table6.1: Ratios Derived from Vertical Analysis

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 Chapter 7

COMMON-SIZED FINANCIAL STATEMENTS

7.1 Introduction to Common-Sized Financial Statements

Common-sized financial statements express all line items as a percentage of a key figure—
sales in the income statement and total assets or liabilities in the balance sheet. This technique
is a form of vertical analysis used for comparing financial statements across time periods,
companies, or industries, regardless of size.

7.2 Purpose of Common-Sizing

 Standardizes financial information

 Enables comparison across firms and industries

 Highlights internal structure of financials

 Aids in spotting inefficiencies or strengths

7.3 Common-Sized Income Statement

Definition: Each line item is shown as a percentage of Net Sales.

Formula: Common Size % = (Item Amount / Net Sales) × 100

Example: ABC Ltd. – Common-Sized Income Statement (FY 2024)

7.4 Common-Sized Balance Sheet

Definition: Each item is presented as a percentage of Total Assets (or Total Liabilities +
Equity).

Formula: Common Size % = (Item Amount / Total Assets) × 100

Example: XYZ Ltd. – Common-Sized Balance Sheet (FY 2024)

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7.5 Advantages of Common-Sized Statements

 Comparability: Enables analysis across companies, industries, or periods regardless of

size.

 Clarity: Simplifies structure for stakeholders unfamiliar with financial jargon.

 Spot Trends: Helps track relative changes over time.

 Focus on Proportions: Emphasizes relationships between line items.

7.6 Application Areas

 Cross-sectional analysis: Comparing similar firms in an industry.

 Time series analysis: Reviewing financial structure over several years.

 Cost control: Identifying whether certain expenses are growing disproportionately.

 Strategic planning: Understanding areas to optimize or restructure.

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 Chapter-8

LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS

8.1 Dependence on Historical Data

Financial statements are primarily based on past performance, which may not reflect future
potential. External shocks, market disruptions, or strategic shifts can render historical data
irrelevant.

Implication:

 Limits forward-looking decision-making

 May lead to inaccurate projections

8.2 Accounting Policies and Estimates

Companies have discretion over accounting methods within regulatory frameworks (e.g.,
depreciation method, inventory valuation, revenue recognition).

Implication:

 Comparability between firms is compromised

 Management bias or manipulation can distort analysis

Examples:

 One firm uses Straight-Line Depreciation, another uses Diminishing Balance

 FIFO vs. LIFO inventory valuation can alter profits during inflation

8.3 Non-Financial Information is Ignored

Qualitative factors like:

 Brand reputation

 Customer satisfaction

 Employee morale

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  Regulatory compliance

Are not reflected in financial statements, yet they significantly impact long-term
performance.

Implication:

 Analysis may provide an incomplete picture

 Risk factors may be overlooked

8.4 Inflation and Currency Fluctuations

Financial statements are often presented in nominal terms, ignoring inflation effects.
Additionally, multinational companies face exchange rate volatility, which can distort
consolidated figures.

Implication:

 Assets may be undervalued

 Earnings may be inflated or deflated artificially

8.5 Window Dressing and Creative Accounting

Firms may manipulate financial statements to present a better picture, especially before
fundraising, IPOs, or loans.

Examples:

 Postponing expenses

 Recording fictitious revenue

 Accelerating income recognition

Implication:

 Ratios and analysis become misleading

 Investors may make flawed decisions

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8.6 Limited Predictive Power

Ratios and statements often fail to capture future events such as:

 Market crashes

 Policy changes

 Product failures or breakthroughs

Implication:

 Financial analysis is a lagging indicator

 Forward-looking tools (forecasts, budgets) are also needed

8.7 Sector and Industry Differences

Benchmarks differ significantly across industries. A high debt-equity ratio may be acceptable
in capital-intensive sectors but risky inservice industries.

Implication:

 Ratios cannot be interpreted in isolation

 Context is essential for meaningful insights

 Economic cycles (recession or boom)

8.8 Consolidation and Complexity

Group financials may aggregate performance across multiple subsidiaries, masking the
performance of individual units.

Implication:

 Poor-performing subsidiaries may be hidden

 Holding company analysis becomes comple

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8.9 Real-World Implications

Case Study: Enron (2001)

 Used off-balance sheet entities to hide debt

 Financial ratios were misleading

 Investors were unaware of true risk exposure

Lesson:

A purely financial analysis without scrutiny can lead to disastrous consequences.

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 CONCLUSION

1. The Profit & Loss Statement is a vital tool in financial analysis. It tells the story of how a
business earns and spends money, providing valuable insights into its operational
performance, cost structure, and profitability. By mastering the interpretation of the P&L,
analysts, investors, and managers gain a powerful advantage in making strategic
decisions, evaluating business health, and ensuring long-term sustainability.

2. The balance sheet is a critical document for evaluating a company’s financial health,
resource allocation, and long-term stability. When combined with the income statement
and cash flow statement, it provides a comprehensive view of the company’s overall
position. Understanding and analyzing balance sheets equips stakeholders with the tools
to assess risk, determine value, and guide strategic decision-making.

3. The cash flow statement offers a real-time view of a company’s liquidity and financial
agility. It is essential for evaluating operational viability, investment capacity, and
solvency. Unlike other financial statements, it cuts through accounting treatments to show
the true cash impact of decisions and activities.

4. Financial ratios are powerful diagnostic tools when used correctly. They offer valuable
insights into a company’s operational efficiency, financial stability, and investment
potential. However, for meaningful interpretation, they must be analyzed in context—
over time, against industry norms, and alongside other financial statements.

5. Vertical and Horizontal Analysis are essential tools for financial diagnostics. While
horizontal analysis reveals trends over time, vertical analysis simplifies cross-sectional
comparisons. Their joint use equips decision-makers with a well-rounded, clear view of
the financial landscape.

6. Common-sized financial statements are a powerful analysis tool, especially when size-
neutral comparisons are required. They bring out hidden proportions, help monitor
internal structure, and form a foundational part of comparative financial analysis. For
holistic insight, they should be used alongside other techniques like ratio analysis and
trend analysis.

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7. Financial statement analysis is a valuable decision-making tool, but it has inherent
limitations. For a complete and realistic picture, users must understand its boundaries,
apply contextual judgment, and complement it with other forms of analysis. A balanced,
critical approach leads to smarter, more informed decisions.

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 REFERENCE

1. Brigham, E.F., & Houston, J.F. (2019). Fundamentals of Financial Management

(15th ed.). Cengage Learning.

2. Khan, M.Y., & Jain, P.K. (2018). Financial Management: Text, Problems and Cases
(8th ed.). McGraw-Hill Education India.

3. Fraser, L.M., & Ormiston, A. (2015). Understanding Financial Statements (10th

ed.). Pearson Education.

4. Wild, J.J., Subramanyam, K.R., & Halsey, R.F. (2014). Financial Statement
Analysis (11th ed.). McGraw-Hill Education.

5. Gibson, C.H. (2012). Financial Reporting and Analysis (13th ed.). South-Western
Cengage Learning.

6. White, G.I., Sondhi, A.C., & Fried, D. (2003). The Analysis and Use of Financial
Statements (3rd ed.). Wiley.

7. Horngren, C.T., Sundem, G.L., & Elliott, J.A. (2010). Introduction to Financial
Accounting (10th ed.). Pearson.

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