ACCA Applied Knowledge · Financial Accounting

Importance and purpose of analysis of financial statements: formula sheet

Full chapter guide

Key formulas

Three areas of analysis: Performance + Financial position + Cash flows; Say which area the user cares about before choosing any measure.
Bases of comparison: Prior years, other entities or industry averages, budgets or targets; A single figure means little unless compared with something.
Answer structure: User → Need → Measure → Conclusion; A reliable pattern for any 'why analyse' question.
Primary users (Conceptual Framework): Primary users = existing and potential investors + lenders + other creditors; These groups provide resources to the entity and cannot demand information directly. Other users may find the reports useful but are not the primary target.
Internal vs external users: Internal = managers and directors; External = everyone else; Internal users can request management accounts. External users rely on published financial statements.
User-to-need link: User → decision → information needed; Use this chain in every written answer. It stops you listing users without explaining their needs.
Core limitations checklist: Historical data | Different accounting policies | Window dressing | Lack of comparability | Non-financial factors ignored | Inflation | Single-date snapshot; Use this list to structure any written or multiple-response answer.
Window dressing effect on current ratio: Current ratio = current assets ÷ current liabilities; If the ratio is above 1, using cash to repay a payable just before year end raises the ratio. If it is below 1, the same action lowers it.
Like-for-like rule: Compare same formula, same policies, same industry, same period; If any of these differ, the comparison is weakened.
Percentage change (trend): (Current year − Prior year) ÷ Prior year × 100%; Use the earlier year as the base. A fall gives a negative result.
Variance against budget: Actual − Budget; State whether it is favourable or adverse. Express as a % of budget to judge size.
Common-size (vertical) analysis: Line item ÷ Base figure × 100%; Base is revenue for profit or loss, and total assets for the statement of financial position. It makes entities of different sizes comparable.
Index number (trend): Year figure ÷ Base year figure × 100; Base year is set to 100. Useful for comparing several years at a glance.

Quick revision

Analysis turns reported figures into information for decisions.
It looks at performance, financial position and cash generation.
Investors want returns and risk; lenders want ability to repay.
Suppliers want to know if they will be paid on time.
Employees want job security and the ability to pay wages.
Governments want information for tax and statistics.
Common bases of comparison: past periods, other entities, industry averages, budgets.
Comparing with prior periods shows trends within one business.
Comparing with other entities needs similar activities and similar accounting policies.
Financial statements are historical, so they may not predict the future.
Year-end figures may not represent the whole year, for example seasonal businesses.
Ratios give clues, not answers; always look for the cause behind a change.

Common mistakes

Listing users without explaining what they need. Fix: Always add one phrase on the decision each user makes, such as lenders deciding whether to lend.
Treating profit as the only thing analysed. Fix: Cover performance, financial position and cash flows. A profitable business can still run out of cash.
Treating managers as external users of published accounts. Fix: Managers are internal users. They use management accounts and can ask for any information they need.
Saying all users need the same information. Fix: Always state each user's decision first. Lenders focus on repayment, investors on return and growth.
Saying ratios are useless. Fix: Say ratios are useful but must be used with care and with other information.
Confusing window dressing with fraud or error. Fix: Window dressing is timing of genuine transactions near year end to improve appearance, not necessarily an error or illegal act.
Calling a comparison with last year cross-sectional analysis. Fix: Time = trend. Other entities at the same time = cross-sectional.
Using the later year as the base for percentage change. Fix: Always divide by the earlier (base) year figure.

Exam tips

Always name the user from the question and write about that user, not users in general.
In objective tests, match each option to a user. Wrong options usually describe a different user's need.
In written style answers, use the pattern user, need, measure, comparison. It earns marks quickly.
Mention cash flows as well as profit. Examiners often test the difference.
Do not overclaim. Say analysis supports decisions, it does not make them.
In objective tests, find the user first, then the decision. The correct option usually matches that decision directly.
For multiple response questions, select exactly the stated number and check each choice against the user named.
Remember internal users do not rely on published accounts. This is a common trap.