Every business needs to prepare basic financial statements that summarize its operating results and financial position for a particular period. These statements primarily include: income statement, balance sheet and cash flow statement.
Thus, the purpose of preparing these statements is to ascertain the profitability and financial soundness of a business. But the detailed information reflected in such statements alone is not sufficient to reach at meaningful managerial conclusions. Therefore, a detailed financial analysis and interpretation of these statements is required using various tools and techniques.
This analysis helps to understand the relationship between various components showcased in each of these statements. So, one of the tools commonly used to undertake financial statement analysis is creating comparative financial statements. Other techniques include:
This article talks about Comparative Financial Statements Analysis. Hence, let’s understand:
- what are comparative financial statements,
- how such statements are prepared and
- why are these comparative statements important.
What Are Comparative Financial Statements?
Preparing Comparative Financial Statements is the most commonly used technique for analyzing financial statements. This technique determines the profitability and financial position of a business by comparing financial statements for two or more time periods. Hence, this technique is also termed as Horizontal Analysis. Typically, income statement and balance sheet are prepared in a comparative form to undertake such an analysis.
Furthermore, there is a provision attached with comparing the financial data showcased by such statements. This relates with making use of the same accounting principles for preparing each of the comparative statements. In case same accounting principles are not followed to prepare such statements, then the difference must be disclosed in the footnote below.
Comparative Balance Sheet
A comparative balance sheet showcases:
- Assets and liabilities of a business for the previous year as well as the current year
- Changes (increase or decrease) in such assets and liabilities over the year both in absolute and relative terms
Thus, a comparative balance sheet not only gives a picture of the assets and liabilities in different accounting periods. It also reveals the extent to which the assets and liabilities have changed during such periods.
Furthermore, such a statement helps managers and business owners to identify trends in the various performance indicators of the underlying business.
What To Study While Analyzing A Comparative Balance Sheet?
A business owner or a financial manager should study the following aspects of a comparative balance sheet:
1. Working Capital
2. Changes in Long-Term Assets, Liabilities and Capital
The next component that a financial manager or a business owner needs to analyze is the change in the fixed assets, long-term liabilities and capital of a business. This analysis helps each of the stakeholders to understand the long-term financial position of a business.
Steps To Prepare a Comparative Balance Sheet
1. Step 1
Firstly, specify absolute figures of assets and liabilities relating to the accounting periods considered for analysis. These amounts are mentioned in Column I and Column II of the comparative balance sheet.
2. Step 2
Find out the absolute change in the items mentioned in the balance sheet. This is done by subtracting the previous year’s item amounts from the current year ones. This increase or decrease absolute amounts are mentioned in Column III of the comparative balance sheet.
3. Step 3
Finally, calculate the percentage change in the assets and liabilities of the current year relative to the previous year. This percentage change in assets and liabilities is mentioned in Column V of the comparative balance sheet.
Percentage Change = (Absolute Increase or Decrease)/Absolute Figure of the Previous Year’s Item) * 100
So, let’s understand a comparative balance sheet through an example. Consider the following balance sheets of M/s Kapoor and Co as on December 31st, 2017 and December 31st, 2018 for the illustration.
Balance Sheet of M/s Kapoor and Co. as December 31, 2017 and December 31, 2018.
Comparative Balance Sheet of M/s Kapoor and Co. as on December 31, 2017 and December 31, 2018.
As we can see in the comparative balance sheet above, the current assets of Kapoor and Co. have decreased by Rs 35,200 in the year 2018 over 2017. On the other hand, the current liabilities have decreased by Rs 27,000 only. Now, such a change does not have a negative impact on the liquidity position of M/s Kapoor and Co. This is because current assets have decreased by 33.9% whereas current liabilities have declined by 51.5%.
Secondly, cash and bank balance of Kapoor and Co. has decreased by 91.5%. This indicates a negative cash position of the company. It further hints towards the fact that the company might find it challenging to meet its short-term obligations.
Next, the long-term debt of M/s Kapoor and Co. has increased by 62.5%. On the other hand, the owner’s equity has improved by only 34%. This indicates that the company is way too dependent on the external lenders thus leading to a great financial risk for the firm.
Finally, there is a considerable increase seen in the fixed assets of the company. Accordingly, the fixed assets increased by Rs 79,000 or 64.9% from the year 2017 to 2018. This was on account of the huge addition made to the plant and machinery by the company in the given accounting periods. Plant and machinery increased by Rs 95,200 that is by 153.5%. Such additional machinery lead to an incredible improvement in the production capacity of the company during the year. This expenditure was provided for by the company proprietors and the external lenders.
Comparative Income Statement
A comparative income statement showcases the operational results of the business for multiple accounting periods. It helps the business owner to compare the results of business operations over different periods of time. Furthermore, such a statement helps in detailed analysis of the changes in line wise items of income statement.
The format of comparative income statement puts together several income statements into a single statement. This helps the business owner in understanding the trends and measuring the business performance over different time periods. Apart from comparing income statements of its own business over different time periods, a business owner can compare the operating results of its competitor firms as well.
Thus, this analysis helps the business owner to compare his business performance with other businesses in the industry. So, business owner can also understand the various causes that lead to changes over different accounting periods. This is achieved by comparing the operating results of the business over multiple accounting periods.
What To Study While Analyzing A Comparative Income Statement?
1. Comparing Sales With Cost of Goods Sold
Changes in the sales in the given accounting periods should be compared with the changes in the cost of goods sold for the same accounting periods.
2. Change in Operating Profits
Change in the operating profits should be analyzed.
3. Profitability of a Business
Understanding the overall profitability of a business concern taking into consideration the changes in the net profit of the given accounting periods.
Steps To Prepare A Comparative Income Statement
Firstly, specify absolute figures of items such as cost of goods sold, net sales, selling expenses, office expenses etc. relating to the accounting periods considered for analysis. These amounts are mentioned in Column I and Column II of the comparative income statement.
2. Step 2
Find out the absolute change in the items mentioned in the income statement. This is done by subtracting the previous year’s item amounts from the current year ones. This increase or decrease in absolute amounts are mentioned in Column III of the comparative income statement.
3. Step 3
Finally, calculate the percentage change in the income statement items of the current year relative to the previous year. This percentage change in items is mentioned in Column V of the comparative income statement.
Now given this, let’s try to understand how a comparative statement is interpreted using a example. Consider the following income statement for M/s Singhania for the years ended December 31st, 2017 and December 31st, 2018.
Income Statement of M/s Singhania as on December 31, 2017 and December 31, 2018.
Comparative Income Statement of M/s Singhania For The Years Ended December 31, 2017 and December 31, 2018.
As is evident from the above comparative income statement, the sales of M/s Singhania increased by Rs 20,400 during 2018 as against 2017. However, the cost of goods sold for the company increased by just Rs 15,000 in the same period. If you see carefully, sales increased by 12% whereas the cost of goods sold increased by 14.3%. Thus, the Gross Profit for M/s Singhania did not increase significantly. Now, there can be several reasons for accounting lower Gross Profit during the year:
Increase In Cost of Goods Sold
Firstly, a higher increase in cost of goods sold can be on account of either increased sales volume or higher input cost. Furthermore, it is evident that the cost of goods sold for the company improved as an outcome of increased sales volume. This is because the sales increased during the year.
Now, the sales value would have increased significantly if the company would have made sales at the previous sales price. But that is not the case as sales value did not change to a greater extent. This hints towards the fact that the incremental sales have been made at a price lower than the sales price.
Furthermore, this analysis is supported by the increase in the advertisement expenses of the company for the year 2018. These increased by 33% which is much higher as against the increase in net sales that was just 12%. Thus, this entire scenario indicates that it was quite challenging to sell the goods during 2018.
Hence,the company to increased its advertisement cost significantly and reduced the selling price in order to achieve higher sales volume. Also, This scenario could be an outcome of a new product launch. In such a case, the company had to spend huge amount on advertisement and reduce selling price for market penetration.
Increase In Other Income and Decrease in Other Expenses
There has been a significant increase in “Other Income” both in absolute and relative terms. Also, there has been a substantial decrease in “Other Expenses” both in absolute and relative terms. Thus, these items on the income statement lead to an improvement in the Profit Before Tax for the year 2018 as against 2017. Hence, such a fact indicates that the company gave more importance to earning non-operating profits over operating one.