Which Tool Answers Which Question
Chapter Twenty-Two
Syllabus topic 5, "Comparative evaluation of financial statements using Trend Analysis, Comparative Statements and Common Size Statements for assessing profitability, liquidity and financial stability."
Pages 57 to 59 of 162
In one line
Trend analysis shows direction over years, the comparative statement shows what moved between two years and by how much, and the common size statement shows structure with size removed; profitability needs all three, liquidity needs the comparative statement, and financial stability needs the common size statement.
The evaluation, tool by tool
| Trend analysis | Comparative statement | Common size statement | |
|---|---|---|---|
| Best at | Direction and speed over a run of years | The size and the proportion of a single year's change | Structure, and comparison between companies |
| Blind to | The rupee magnitude, and any single year's detail | Anything before last year | Size and growth entirely |
| Base | A chosen base year | The earlier of two years | The statement's own total |
| Years needed | Five or more to be useful | Exactly two | One is enough |
| Where it misleads | A badly chosen base | A large percentage on a small figure | A business that shrinks with its shape unchanged |
Against the three objects MU names
Profitability.
| Tool | What it contributes |
|---|---|
| Trend | Whether the profit is growing, and whether it is growing as fast as sales, over a run |
| Comparative | Which item moved this year: cost of goods sold, or an overhead, or a non-operating item |
| Common size | The margin itself: gross profit and net profit as paise in the rupee, which is profitability defined |
The common size statement is the primary tool for profitability, because profitability IS a percentage of sales. The other two say how it got there and where it is going.
Liquidity.
| Tool | What it contributes |
|---|---|
| Trend | Whether debtors and stock are growing faster than sales over a run, which is a slow liquidity warning |
| Comparative | The movement in current assets against current liabilities, which is the direct test |
| Common size | Working capital as a share of capital employed, which is structural rather than liquid |
The comparative statement is the primary tool for liquidity, because liquidity is about the relation between two moving groups and this is the tool that shows both moving. Its limitation is real: as the chapter on it showed, working capital can rise while the current ratio falls, so the comparative statement must be read with the current ratio beside it, and that is Module III.
Financial stability, meaning long-term solvency.
| Tool | What it contributes |
|---|---|
| Trend | Whether borrowing has grown faster than owners' funds over the years |
| Comparative | Which source financed this year's growth |
| Common size | The mix of owners' funds and borrowed funds, which is stability defined |
The common size balance sheet is the primary tool for stability, because stability is a proportion: what share of the capital is other people's money.
The summary table, which is the answer
| Object | Primary tool | Why | Second tool |
|---|---|---|---|
| Profitability | Common size income statement | Profitability is a percentage of sales, and this states it directly | Trend, for the direction |
| Liquidity | Comparative balance sheet | Liquidity is the relation between two moving groups | Trend, for debtors and stock against sales |
| Financial stability | Common size balance sheet | Stability is the proportion of borrowed to owned | Trend, for whether borrowing outran the owners' funds |
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