Vertical Analysis and Common Size Statements:
Definition and Explanation of Vertical Analysis and Common Size Statements:
Vertical analysis is the procedure of preparing and presenting common size statements. Common size statement is one that shows the items appearing on it in percentage form as well as in dollar form.
Each item is stated as a percentage of some total of which that item is a part. Key financial changes and trends can be highlighted by the use of common size statements.
Common size statements are particularly useful when comparing data from different companies. For example, in one year, Wendy’s net income was about $110 million, whereas McDonald’s was $1,427 million. This comparison is somewhat misleading because of the dramatically different size of the two companies. To put this in better perspective, the net income figures can be expressed as a percentage of the sales revenues of each company, Since Wendy’s sales revenue were $1,746 million and McDonald’s were $9,794 million, Wendy’s net income as a percentage of sales was about 6.3% and McDonald’s was about 14.6%.
One application of the vertical analysis idea is to state the separate assets of a company as percentages of total sales. A common type statement of an electronic company is shown below:
*Each asset in common size statement is expressed in terms of total assets, and each liability and equity account is expressed in terms of total liabilities and stockholders’ equity. For example, the percentage figure above for cash in 2002 is computed as follows:
Notice from the above example that placing all assets in common size form clearly shows the relative importance of the current assets as compared to the non-current assets. It also shows that the significant changes have taken place in the composition of the current assets over the last year. Notice, for example, that the receivables have increased in relative importance and that both cash and inventory have declined in relative importance. Judging from the sharp increase in receivables, the deterioration in cash position may be a result of inability to collect from customers.
The main advantages of analyzing a balance sheet in this manner is that the balance sheets of businesses of all sizes can easily be compared. It also makes it easy to see relative annual changes in one business.
Another application of the vertical analysis idea is to place all items on the income statement in percentage form in terms of sales. A common size statement of this type of an electronics company is shown below:
*Note that the percentage figures for each year are expressed in terms of total sales for the year. For example, the percentage figure for cost of goods sold in 2002 is computed as follows:
By placing all items on the income statement in common size in terms of sales, it is possible to see at a glance how each dollar of sales is distributed among the various costs, expenses, and profits. And by placing successive years’ statements side by side, it is easy to spot interesting trends. For example, as shown above, the cost of goods sold as a percentage of sales increased from 65.6% in 2001 to 69.2% in 2002. Or looking at this form a different view point , the gross margin percentage declined from 34.4% in 2001 to 30.8% in 2002. Managers and investment analysis often pay close attention to the gross margin percentage since it is considered a broad gauge of profitability. The gross margin percentage is computed by the following formula:
Gross margin percentage = Gross margin / Sales
The gross margin percentage tends to be more stable for retailing companies than for other service companies and for manufacturers. Since the cost of goods sold in retailing exclude fixed costs. When fixed costs are included in the cost of goods sold figure, the gross margin percentage tends to increase of decrease with sales volume. The fixed costs are spread across more units and the gross margin percentage improves.
While a higher gross margin percentage is considered to be better than a lower gross margin percentage, there are exceptions. Some companies purposely choose a strategy emphasizing low prices and (hence low gross margin). An increasing gross margin in such a company might be a sign that the company’s strategy is not being effectively implemented.
Common size statements are also very helpful in pointing out efficiencies and inefficiencies that might other wise go unnoticed. To illustrate, selling expenses, in the above example of electronics company , increased by $500,000 over 2001. A glance at the common-size income statement shows, however, that on a relative basis, selling expenses were no higher in 2002 than in 2001. In each year they represented 13.5% of sales.
You may also be interested in other articles from “financial statement analysis” chapter:
Other Related Accounting Articles:
- Trend Analysis / Horizontal Analysis in financial Statements
- Current Assets to Proprietor’s Fund Ratio
- Fixed Assets Turnover Ratio
- Expense Ratio
- Operating Ratio
- Proprietary Ratio or Equity Ratio
- Return on Equity Capital (ROEC) Ratio
- Financial Statement Analysis
- Working Capital Turnover Ratio
- Fixed Assets to Proprietor’s Fund Ratio
Download E accounting book in MS-word format for just 20 $ - Click here to Download