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Ch 11 · Financial Analysis · T.S. Grewal — Analysis of Financial Statements

Financial
Statement Analysis

50 MCQs 30 Flashcards T.S. Grewal Class 12 Updated May 2026
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Chapter Overview

Chapter 11 is the introductory chapter to the unit on Analysis of Financial Statements. It defines Financial Statement Analysis (FSA) as the systematic process of reviewing, analysing and interpreting a firm's financial statements so that users can take better economic decisions. FSA begins only AFTER the statements are prepared — its inputs are the Statement of Profit & Loss, the Balance Sheet and the Cash Flow Statement; its outputs are interpretations, ratios and inferences.

The chapter covers the objectives of FSA (judging earning capacity, financial position, short-term and long-term solvency, growth potential), its users — internal (management) and external (shareholders, lenders, trade creditors, government, employees, customers) — and the five main tools: Comparative Statements (horizontal), Common-Size Statements (vertical), Trend Analysis (multi-year), Ratio Analysis and the Cash Flow Statement. It distinguishes vertical analysis (common-size, single period) from horizontal analysis (time-series, two or more periods), and explains how Trend Analysis indexes a series of years against a chosen base year set at 100.

Finally, the chapter sets out the limitations of FSA — historical data does not predict the future; qualitative factors (management quality, brand, morale) are ignored; figures can be subject to window dressing; differences in accounting policies (depreciation method, inventory valuation) distort inter-firm comparison; and price-level changes are not reflected in historical-cost statements. The chapter is theory-light and concept-heavy — it sets up the toolkit applied in detail in Chapters 12 (Comparative & Common-Size), 13 (Ratios) and 14 (Cash Flow).

What You'll Learn
Key Concepts
Definition
Meaning of FSA
Systematic process of reviewing, analysing and interpreting financial statements so that users (internal and external) can take better decisions.
Why?
Objectives of FSA
Earning capacity, financial position, short-term liquidity, long-term solvency, growth potential and inter-firm comparison.
Who?
Users of FSA
Management, shareholders, long-term lenders, short-term creditors, government / tax authorities, employees and unions, customers and competitors.
Toolkit
6 Tools / Techniques
Comparative Statements, Common-Size Statements, Trend Analysis, Ratio Analysis, Cash Flow Statement (and the rarely used Fund Flow Statement).
Direction
Vertical vs Horizontal
Vertical = single period, item as % of base (Common-Size). Horizontal = across periods, change in absolute / % terms (Comparative, Trend).
Multi-year
Trend Analysis
Pick a NORMAL base year, set it at 100, express each subsequent year as a percentage of the base. Reveals long-run direction.
Caveats
Limitations of FSA
Historical data; qualitative factors ignored; window dressing; accounting-policy variation; price-level changes; misleading without context.
Risk
Window Dressing
Deliberate presentation of figures to look better than reality — postponed expenses, advanced revenue, hidden slow stock. Distorts FSA.
Boundary
FSA vs Audit
Audit certifies that statements give a 'true and fair view' (truthfulness). FSA interprets those statements and draws inferences (meaning).
Sample MCQs
Q1. Financial Statement Analysis is BEST described as the:
A. Systematic process of reviewing and analysing a firm's financial statements to support better decisions
B. Routine bookkeeping work of recording day-to-day business transactions
C. Statutory audit of a company's books carried out under the Companies Act
D. Preparation of the Trading and Profit & Loss Account at year end
FSA is the systematic process of reviewing, analysing and interpreting a firm's financial statements so that users can make better economic decisions. It is distinct from bookkeeping, audit and statement preparation.
Q2. Revenue from Operations of a firm was ₹4,00,000 in 2023-24 and ₹5,00,000 in 2024-25. In a Comparative Statement of Profit & Loss, the percentage change in Revenue from Operations is:
A. 20%
B. 25%
C. 80%
D. 125%
% Change = (Current − Previous) ÷ Previous × 100 = (5,00,000 − 4,00,000) ÷ 4,00,000 × 100 = 25%. The PREVIOUS year is the base (denominator) in a Comparative Statement.
Q3. Revenue from Operations for the years 2021-22, 2022-23 and 2023-24 were ₹5,00,000, ₹6,00,000 and ₹7,50,000 respectively. Taking 2021-22 as base, the trend percentages for the three years (in order) are:
A. 100, 125, 150
B. 100, 120, 150
C. 100, 110, 130
D. 100, 120, 140
Base year (2021-22) = 100. 2022-23 = (6,00,000 ÷ 5,00,000) × 100 = 120. 2023-24 = (7,50,000 ÷ 5,00,000) × 100 = 150. So the trend series is 100, 120, 150.
Frequently Asked Questions
What is Financial Statement Analysis?
Financial Statement Analysis (FSA) is the systematic process of reviewing, analysing and interpreting a company's financial statements so that users can take better economic decisions. It begins AFTER the statements are prepared and converts raw figures into meaningful information by establishing relationships across years (trends), within a single year (common-size structure) and between related items (ratios).
Who uses Financial Statement Analysis?
Internal users — management — use FSA for planning, control and decisions. External users include shareholders / investors (earning capacity, dividends, growth), long-term lenders (long-term solvency), short-term creditors (liquidity), government and tax authorities (tax-paying capacity, regulation), employees and unions (bonus and job security under the Payment of Bonus Act 1965), and customers (continuity of supply).
What are the main tools of Financial Statement Analysis?
The five main tools are: Comparative Statements (year-on-year change in absolute and percentage terms), Common-Size Statements (each item as a percentage of a base — Revenue from Operations or Total Assets), Trend Analysis (multi-year, base year set at 100), Ratio Analysis (relationships between two related figures — liquidity, solvency, activity, profitability) and the Cash Flow Statement (movement of cash and cash equivalents under Operating, Investing and Financing activities, per AS-3 / Ind AS 7).
What is the difference between vertical and horizontal analysis?
Vertical Analysis (Static / Common-Size) studies one period at a time, expressing every item as a percentage of a base in the same period — Revenue from Operations for the Statement of P&L and Total Assets for the Balance Sheet. Horizontal Analysis (Dynamic / Time-series) studies change ACROSS periods — Comparative Statements (typically 2-3 years) and Trend Analysis (5+ years with base = 100). Vertical analysis is used to compare structure (especially across firms of different sizes); horizontal analysis is used to study growth and direction over time.
What are the limitations of FSA?
Five recognised limitations: (1) historical data — past trends may not predict the future; (2) qualitative factors are ignored — quality of management, brand value, employee morale and government policy do not appear in the statements; (3) window dressing — figures may be deliberately presented to look better than reality; (4) variation in accounting policies — depreciation method (SLM vs WDV), inventory valuation (FIFO vs Weighted Average) and other choices distort comparison across firms or years; (5) price-level changes — historical-cost statements understate asset values and overstate profits during inflation.
How does Trend Analysis work?
Trend Analysis is a multi-year horizontal analysis (typically 5+ years). A NORMAL year is chosen as the base year and its figures are set at 100. Each subsequent (or earlier) year is then expressed as a percentage of the base-year figure. Trend % = (Item value in year n ÷ Item value in base year) × 100. This makes the long-run direction (rising, falling or stagnant) visible and allows comparison of related items — for example, if Revenue rises to 150 but Material Cost rises to 175 from the same base, gross margins are clearly being squeezed.