Financial Statement Analysis

1.
Financial statement analysis, which is a process of
examining a company's financial statement to develop
strategies, is a valuable skill for financial analysts, accountants
and other finance professionals. The world of is dynamic and
competitive, with financial metrics playing a critical role in
shaping strategies and operations. Two common types of
financial statement analysis are horizontal analysis, also
known as trend analysis, and vertical analysis, termed
common size financial statement analysis.. These type of
analysis can also help a company secure investors. Investors,
who often conduct comprehensive research into a company's
financial health. Businesses face ever-changing market
conditions and competitive pressures, tools like horizontal and
vertical analysis are indispensable for financial analysts like
Sarah. The following points explain how these analytical
methods prove crucial in assessing the financial health of a
company:

Horizontal Analysis:
The horizontal analysis is a dynamic tool that
assesses financial data trends over several
years. Financial analysts look at financial trends over
periods of time especially quarters or years. In this data
driven buzzling world where every percentage point
matters, this analysis can reveal the proportional impact of
cost of goods sold, operating expenses, and other
financial elements on net sales. Typically, financial
analysts perform horizontal analysis before vertical
analysis, and it is usually the most useful for companies
that have been operating for a long period of time. For
example, Sarah’s analysing income statements for three
consecutive years, she would calculate the change in
revenue, expenses, and net income from year to year.
This helps to identify if these items are increasing or
decreasing over time. It basically helps stakeholders
understand the past, anticipate the future, make informed
decisions and is indeed indispensable in the dynamic
world of finance for several reasons:

 Tracking trends: Horizontal analysis helps financial

analysts to identify patterns and trends over time by
comparing historical data. By comparing financial
statements, such as income statements, balance
sheets, and cash flow statements, over multiple
periods, analysts can spot patterns and changes in
performance indicators. This enables them to spot
recurring patterns in revenue growth, expense
management, and profit margins, which are important
for understanding the company's financial trajectory.

 Performance evaluation: It allows for a comparative

evaluation of a company's performance over time.
Examining trends through horizontal analysis
provides insights into the company's performance
relative to its past performance and industry
benchmarks. By analysing how key financial metrics
have changed from one period to another,
stakeholders can assess whether the company is
improving, declining, or remaining stagnant in its
financial performance. This information is vital for
making strategic decisions and assessing
management effectiveness.

 Forecasting: Forecasting based on horizontal

analysis helps in setting realistic goals and
expectations for future periods. While past
performance is not always indicative of future results,
understanding historical trends through horizontal
analysis aids in forecasting future performance more
accurately and can provide valuable insights for
financial planning and budgeting purposes. By
 analysing past trends, financial analysts can make
informed projections about future revenue, expenses,
and profitability, thereby supporting budgeting and
planning processes.

 Decision making: Investors use horizontal analysis

to evaluate the financial health and growth potential
of companies before making investment decisions.
Whether it's identifying areas for improvement,
reallocating resources, or capitalizing on emerging
opportunities, horizontal analysis guides decision-
makers in charting the company's course effectively.
By examining historical financial trends, investors can
assess the company's stability, growth prospects,
and overall investment attractiveness. This analysis
aids investors in making informed decisions about
allocating capital.

Vertical Analysis:
Vertical analysis involves the assessment of financial
statements to determine the relative proportions of
different line items to a base item within the same period.
It focuses on a specific reporting period, dissecting
financial statements to identify the proportional
relationship between various line items. Vertical analysis
translates figures in financial statements to percentages of
a base figure, which has a value of 100% since, using
percentages can make the data easier to visualize and
understand. For example, in an income statement, each
expense item might be expressed as a percentage of total
revenue. In a balance sheet, each asset, liability, and
equity item might be expressed as a percentage of total
assets. Vertical analysis can make it easier to understand
the connection between each component and is indeed
indispensable in the dynamic world of finance for several
reasons:
 Comparative study: Vertical analysis allows
financial analysts to compare line items within a
single period by expressing each item as a proportion
of a base figure, typically total revenue or assets.
This tool can be largely used by financial analysts to
analyse their company spending. It facilitates
comparative analysis across different companies,
industries, or time periods. This comparative analysis
helps in benchmarking performance and identifying
outliers or areas of concern. By expressing financial
data as percentages, it standardizes the information
and makes it easier to compare the relative
proportions of various line items.

 Ratio Analysis: Vertical analysis serves as a

foundation for calculating various financial ratios,
such as profitability ratios, liquidity ratios, and
solvency ratios which offer valuable insights into the
company's financial performance, stability, and risk
profile. These help in assessing liquidity, profitability,
efficiency, and risk, guiding decision-making
processes for investors, creditors, and management.
By expressing financial data as percentages,
analysts can easily compute these ratios, which
provide insights into different aspects of the
company's financial condition and performance.

 Evaluating efficiency: Vertical analysis helps in

assessing operational efficiency and leverage within
a company. By examining the vertical relationships
within financial statements, analysts can assess the
efficiency and profitability of various operations and
activities. By examining the composition of various
line items such as expenses or assets, analysts can
identify areas where the company is allocating
resources efficiently. For example, analysing the
proportion of expenses to revenue helps in
 evaluating cost management practices and
operational efficiency. This insight is vital for
assessing financial health and risk management,
especially in a dynamic market environment where
operational efficiency and financial flexibility are
primary.

 Areas of Strength and Weakness: Vertical analysis

helps in identifying areas of strength and weakness
within the company's operations. By investigating the
factors of strength and weakness, financial analysts
recommend strategies to improve profitability, such
as cost-cutting measures or pricing adjustments. By
comparing the proportions of different line items,
analysts can pinpoint areas where resources are
effectively utilized and areas where improvements
are needed. This insight guides strategic decision-
making and resource allocation.

On the whole, together horizontal and vertical analysis

provide Sarah with a comprehensive understanding of her
company's financial health and performance. In the fast-paced,
complex and dynamic world of finance, horizontal and vertical
analysis are hence indispensable tools that enable financial
analysts like Sarah to gain deeper insights into a company's
financial performance, identify key trends and patterns, and
empower stakeholders to make informed decisions about
investments, strategic direction, and resource allocation that
drive sustainable growth and profitability to the company.

2.
A Director's Report is a report prepared by the Board of
Directors of a company and presented to the shareholders at
the Annual General Meeting. It is a document that provides an
overview of a company’s operations, financial performances,
and prospects. It contains essential information about the
company's finances, operations, and managerial structure. The
purpose of the Director's Report is to inform the shareholders
about the performance of the company during the financial year
and the plans of the company. It aims to provide stakeholders
with a clear and accurate picture of the company's performance
and options, which can help build trust and confidence. Rule 8
of the Companies (Accounts) Rules, 2014 in India pertains to
the 'Profit and Loss Account and Balance Sheet'. The rule
specifies various details that need to be included in both the
profit and loss account and the balance sheet, such as the
format of the statements, classifications of various items,
disclosure requirements, and explanatory notes. It also
provides guidance on the presentation of certain items like
provisions, contingencies, reserves, and dividends. This rule
outlines the format and requirements for preparing and
presenting the profit and loss account and balance sheet of a
company. The contents of a Director's Report vary depending
on the requirements of the jurisdiction and the nature of the
company. However, it generally includes a review of the
performance of the company during the financial year, the plans
of the company, and a statement of compliance with the
corporate governance requirements. Compliance with Rule 8
ensures that the financial statements of companies provide
relevant and reliable information to stakeholders for decision-
making purposes.

As the annual general meeting approaches, to help Lisa, the

company secretary to prepare the directors report. Rule 8 of
the Companies (Accounts) Rules, 2014 outlines the content
requirements for the directors' report of a company. Here are
the key components typically included in a directors' report
based on Rule 8:

 Financial summary and highlights : Sub-rule 5(i) of the

said rules provides that the financial summary or highlights
thereof shall be disclosed in the Report. The report must
 be based on the stand alone financial statements of the
company. A review of the company's financial performance
during the financial year, including the revenue and profit
figures, change in financial position and key financial ratios
and indicators. It should be accompanied by the macro-
economic, geo-political, financial, industry specific as well
as any company specific information affecting the business
of the company and the tech market in which it operates,
along with the industry performance.

 Change in the nature of business: Sub-Rule (5)(ii) of

Rule 8 of Companies (Accounts) Rules, 2014 says In case
the firm had commenced any new business or
discontinued/sold or disposed off any of its existing
businesses or hived off any segment or division during the
year, the Report shall disclose the details. The report
should report the changes during the year, in the nature of
business carried on by the company.

 Key managerial personnel: The details of the directors

and key managerial personnel who were appointed or who
have resigned during the year should be mentioned
according to Rule 8(5). It should also include names of the
Directors retiring by rotation at the ensuing annual general
meeting and whether or not they offer themselves for re-
appointment.

 Annual Evaluation: It should contain a statement

indicating the manner in which formal annual evaluation
has been made by the Board of its own performance and
that of its committees and individual directors

 Subsidiaries, Associates and joint ventures : The report

should be prepared based on the stand alone financial
statements of the company and shall contain a separate
section wherein the report of the financial position of each
of the subsidiaries, associates and joint venture
 companies, included in the consolidated financial
statement is presented, and their contribution to the overall
performance of the company during the period under
Report. The report should also l contain the names of
companies which have become or ceased to be its
subsidiaries, joint ventures or associate companies during
the year

 Deposit details : According to Rule 8(5)(v) of Companies

(Accounts) Rules, 2014 details such as deposits accepted
during the year; remaining unpaid or unclaimed as at the
end of the year; any default in repayment of deposits or
payment of interest thereon during the year and details of
National Company Law Tribunal (NCLT)/ (NCLAT) orders
with respect to depositors for extension of time for
repayment and the penalty imposed. Particulars of Loans,
Guarantee and investment should bel disclosed in the
Board’s Report regarding all transactions which is related
to the firm.

 Contracts and Agreements: The report should include

details of contracts, arrangements, transactions with
related parties which are not at arm’s length basis; with
related parties which are at arm’s length basis and with
related parties which are not in the ordinary course of
business and justification for entering into such contract.

 Material orders: Details of significant and material orders

passed by any Regulator, Court, Tribunal, Statutory and
quasi-judicial body, impacting the going concern status of
the company and its future operations should be disclosed
in the report.

 Other disclosures: Other disclosures such as a

statement, wherever applicable, that the consolidated
financial statement is also being presented in addition to
the standalone financial statement of the company, key
 initiatives with respect to Stakeholder relationship,
Customer relationship, Environment, sweat equity shares
Sustainability, Health and Safety should me mentioned.
The reasons for delay, if any, in holding the annual general
meeting and a a statement as to whether cost records are
required to be maintained by the company pursuant to an
order of the Central Government and accordingly such
records and accounts are maintained must also be
reported.

 Corporate Social Responsibility: Disclosure of the

company's CSR initiatives, including details of projects
undertaken, expenditure incurred, and impact
assessment, should be reported if applicable.

 Internal Complaints and Harassments: Details must be

provided on the internal financial control and conflicts
along with disclosures pertaining to the Sexual
Harassment of Women at the Workplace with the details
of number of complaints filed during the financial year,
disposed of during the financial year and pending as at the
end of the financial year.

 Auditor’s Report : The auditors' report on the financial

statements, including any qualifications or observations
made by the auditors should also be included.

 Conservation of energy: The report should include the

following details the company takes to conserve energy-
(a)Steps taken on conservation on energy; (b) steps taken
by the company for utilising alternative source of energy;
(c)the capital investment on energy conservation
equipment

 Technology Absorption: The report should include the

following details the company takes towards the
technology absorption, such as the efforts made towards
 it, the benefits gained through it like cost reduction etc and
if there is any case of imported technology along with its
absorption should be reported in the report

 Foreign exchange: Foreign exchange earned in terms of

actual inflows and the foreign exchange outgoes during
the year in terms of actual outflows should be reported in
the report.

 If a Small company: If it is a thriving tech firm with a One

Person Company and Small Company, then the web
address, number of meetings of the Board, Directors’
Responsibility Statement, details in respect of frauds
reported by auditor, explanations or comments by the
Board on every qualification, reservation or adverse
remark or disclaimer made by the auditor etc should also
be made.

By including these components in the directors' report,

Lisa can ensure compliance with Rule 8 of the Companies
(Accounts) Rules, 2014, and provide shareholders and
stakeholders with a comprehensive overview of the company's
performance, operations and prospects.

3.
(a).

Debt to Equity Ratio:

Debt to Equity Ratio provides insight into a company's
financial structure. It depicts how much debt a company has
compared to its assets. A higher Debt to Equity Ratio indicates
that the company has more debt relative to its equity. This
suggests higher financial leverage and greater risk, as the
company may have higher interest payments and be more
vulnerable to economic downturns. A lower Debt to Equity
Ratio suggests lower financial risk, as the company relies less
on debt financing and has more equity to support its operations.
This ratio measures the proportion of a company's financing
that comes from debt compared to equity.

It is calculated using the following formula,

Debt to Equity Ratio = Total Debt / Shareholders’ Equity

Interest Coverage Ratio :

The interest coverage ratio is a debt and profitability ratio
used to determine how easily a company can pay interest on its
outstanding debt. A higher interest coverage ratio indicates that
the company is more capable of meeting its interest obligations,
as it has more earnings available to cover the interest
expenses. Conversely, a lower ratio suggests that the company
may have difficulty meeting its interest payments and could be
at risk of financial distress. Therefore, lenders and investors
prefer to see higher interest coverage ratios as it indicates a
healthier financial position. It's calculated by dividing a
company's earnings before interest and taxes (EBIT) by its
interest expenses.

The formula for the interest coverage ratio is:

Interest Coverage Ratio = EBIT / Interest Expenses

Let's calculate these ratios for both Style Ltd. and Diva Ltd.:

For Style Ltd.

Debt to Equity Ratio:
Total Debt = Current maturities of long-term
borrowings +Short-term borrowings +
Long-term borrowings
= 26 + 9 + 90
= 125
 Total Equity = Paid-up Share Capital + Retained
Earnings
= 37 + 98
= 135

Debt / Equity Ratio = 125 / 135

Debt / Equity Ratio = 0.926

Interest Coverage Ratio:

EBIT = Operating Profit
= 67
Interest Expense. = 14

Interest Coverage Ratio = 67 / 14

Interest Coverage Ratio = 4.786

For Diva Ltd.

Debt to Equity Ratio:
Total Debt = Current maturities of long-term
borrowings +Short-term borrowings +
Long-term borrowings
= 21+8+80
= 109

Total Equity = Paid-up Share Capital + Retained

Earnings
= 37+73
= 110

Debt / Equity Ratio = 109/110

Debt / Equity Ratio = 0.990

Interest Coverage Ratio:

 EBIT = Operating Profit
= 60
Interest Expense. = 13

Interest Coverage Ratio = 4.615

Interest Coverage Ratio = 4.615

Therefore,

Style Ltd.
Debt / Equity Ratio = 0.93
Interest Coverage Ratio = 4.79

Diva Ltd.
Debt / Equity Ratio = 0.99
Interest Coverage Ratio = 4.62

 Both Style Ltd. and Diva Ltd. have similar Debt to Equity
Ratios, with Style Ltd. being slightly less leveraged
indicating that Style Ltd. relies less on debt financing
relative to its equity. However, both companies have ratios
below 1, suggesting that their equity financing exceeds
their debt financing, which is generally considered a
positive sign.

 Style Ltd. and Diva Ltd. have healthy Interest Coverage

Ratios, indicating that they generate sufficient operating
income to cover their interest expenses. The Interest
Coverage Ratios for both companies are above 4, higher
ratios imply a stronger ability to meet interest obligations,
which is favourable for both companies.

Based on these ratios, both Style Ltd. and Diva Ltd. seem
to be in good financial health, with reasonable leverage to
cover their interest expenses.
3.
(b).

Gross Profit Margin:

Gross profit margin is an analytical metric used to assess
a company’s financial health and is often shown as the gross
profit as a percentage of net sales. It is expressed as a
company's net sales minus the cost of goods sold. Simply, it
measures how efficiently a company is producing and selling its
products or services, as it focuses solely on the direct costs
associated with production. A higher gross profit margin
generally indicates that a company is effectively managing its
production costs and pricing its products or services
competitively. The Gross Profit Margin is calculated by dividing
the gross profit by net sales and expressing it as a percentage.

Gross Profit Margin = (Gross Profit/ Net Sales)*100

Return on Equity:

Return On Equity is a measuring tool of a corporation's

profitability and how efficiently it generates those profits. ROE
indicates the percentage of net income a company earns in
relation to its shareholders' equity. It simply shows how much
profit the company generates with the money shareholders
have invested. A higher ROE suggests that the company is
generating more profit with less investment from shareholders,
which can be a sign of good financial health and effective
management.

ROE = (Net Profit/ Shareholder’s Equity)*100

Style Ltd.
 Gross Profit Margin:
Gross Profit Margin = (Gross Profit/ Net Sales)*100

= (152/300)*100
 = 50.67%

Gross Profit Margin = 50.67%

 Return On Equity:
Return on Equity = (Net Profit/ Shareholder’s Equity)*100

{Shareholder’s Equity = Paid up share capital + Retained earnings}

= {27/(37+98)}*100

= (27/135)*100

= 20

Return on Equity = 20%

Diva Ltd.
 Gross Profit Margin:
Gross Profit Margin = (Gross Profit/ Net Sales)*100

= (140/280)*100

= 50%

Gross Profit Margin = 50%

 Return On Equity:
Return on Equity = (Net Profit/ Shareholder’s Equity)*100

{Shareholder’s Equity = Paid up share capital + Retained earnings}

= {24/(37+73)}*100

= (24/110)*100

= 21.82
 Return on Equity = 21.82%

For Style Ltd.

Gross Profit Margin = 50.67%

Return on Equity = 20%

For Diva Ltd.

Gross Profit Margin = 50%

Return on Equity = 21.82%

Therefore,

On the whole, both companies seem to be performing well

in terms of profitability, with Diva Ltd. having a slightly better
performance in terms of ROE. Style Ltd. and Diva Ltd. have
similar Gross Profit Margins, indicating that they are both
efficient in generating profits from their sales. Diva Ltd. has a
slightly higher ROE compared to Style Ltd., suggesting that
Diva Ltd. generates slightly higher profits in relation to the
equity invested by shareholders. This could imply that Diva Ltd.
is utilizing its shareholder funds more efficiently to generate
profits.