Vertical analysis free essay sample

A method of financial statement analysis in which each entry for each of the three major categories of accounts (assets, liabilities and equities) in a balance sheet is represented as a proportion of the total account. The main advantage of vertical analysis is that the balance sheets of businesses of all sizes can easily be compared. It also makes it easy to see relative annual changes within one business. For example, suppose XYZ Corp. has three assets: cash and cash equivalents (worth $3 million), inventory (worth $8 million), and property (worth $9 million). If vertical analysis is used, the asset column will look like: Cash and cash equivalents: 15% Inventory: 40% Property: 45% This method of analysis contrasts with horizontal analysis, which uses one years worth of entries as a baseline while every other year represents differences in terms of changes to that baseline. Vertical Analysis of Financial Statements Vertical analysis of financial statements is a technique in which the relationship between items in the same financial is identified by expressing all amounts as a percentage a total amount. We will write a custom essay sample on Vertical analysis or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page This method compares different items to a single item in the same accounting period. The financial statements prepared by using this technique are known as common size financial statements. This analysis is performed on the income statement as well as the balance sheet. Balance Sheet: When applying this method on the balance sheet, all of the three major categories accounts (i. e. assets, liabilities, and equity) are compared to the total assets. All of the balance sheet items are presented as a proportion of the total assets. These percentages are shown along with the absolute currency amounts. For example, suppose a company has three assets; cash worth $4 million, inventory worth $7 million and fixed assets worth $9million. The vertical analysis method will show these as Cash: 20% Inventories: 35% Fixed Assets: 45% Income Statement: And when applying this technique to the income statement, each of the expense is compared to the total sales revenue. The expenses are presented as a proportion of total sales revenue along with the absolute amounts. For example, if the sales revenue of a company is $10 million and the cost of sales is $6 million, the cost of sales will be reported as 60% of the sales revenue. The main advantage of using vertical analysis of financial statements is that income statements and balance sheets of companies of different sizes can be compared. Comparison of absolute amounts of companies of different sizes does not provide useful conclusions about their financial performance and financial position. Usually the vertical analysis is performed for a single accounting period to see the relative proportions of different account balances. But it is also useful to perform vertical analysis over a number of periods to identify changes in accounts over time. It can help to identify unusual changes in the behavior of accounts. For example, if the cost of sales has been consistently 45% in the history, then a sudden new percentage of 60% should catch the attention of analysts. Reasons behind this change should be investigated and then measures should be taken to bring this percentage back to its normal level. SECTION 3: VERTICAL ANALYSIS (COMMON-SIZE ANALYSIS) Vertical/Common-size analysis expresses items in a financial statement as a percentage of a single or base amount. This allows analysis of two or more corporations of varying sizes. The calculations used to determine the answers for the vertical analysis must be included in the appendix. I. For an Income Statement, items are usually expressed as a percentage of revenue. Perform vertical analysis in relation to revenue for the following items in the Income Statement for the current year for each of the two corporations. Current Year Revenue 100% COGS Operating Expense Interest Expense Income Tax Expense Net Income Based on the analysis, how have each of the companies performed relative to the following: †¢ Product or Service Cost Control †¢ Operating Cost Control †¢ Debt Servicing †¢ Tax burden †¢ Profitability II. For a Balance Sheet, vertical analysis is performed by expressing amounts as a percentage of total assets. These percentages are then compared to percentages calculated for another corporation (inter-company analysis). Perform common-size analysis of the following for each of the two corporations. Current Year Current Assets Property, Plant and Equipment All Other Assets TOTAL ASSETS 100% Current Liabilities Total Liabilities Stockholder’s Equity Vertical Analysis of the Income Statement The most common use of vertical analysis in an income statement is to show the various expense line items as a percentage of sales, though it can also be used to show the percentage of different revenue line items that make up total sales. An example of vertical analysis for an income statement is shown in the far right column of the following condensed income statement: $ Totals Percent Sales $1,000,000 100% Cost of goods sold 400,000 40% Gross margin 600,000 60% Salaries and wages 250,000 25% Office rent 50,000 5% Supplies 10,000 1% Utilities 20,000 2% Other expenses 90,000 9% Total expenses 420,000 42% Net profit 180,000 18% The information provided by this income statement format is useful not only for spotting spikes in expenses, but also for determining which expenses are so small that they may not be worthy of much management attention. Vertical Analysis of the Balance Sheet The central issue when creating a vertical analysis of a balance sheet is what to use as the denominator in the percentage calculation. The usual denominator is the asset total, but you can also use the total of all liabilities when calculating all liability line item percentages, and the total of all equity accounts when calculating all equity line item percentages. An example of vertical analysis for a balance sheet is shown in the far right column of the following condensed balance sheet: $ Totals Percent Cash $100,000 10% Accounts receivable 350,000 35% Inventory 150,000 15% Total current assets 600,000 60% Fixed assets 400,000 40% Total assets $1,000,000 100% Accounts payable $180,000 18% Accrued liabilities 70,000 7% Total current liabilities 250,000 25% Notes payable 300,000 30% Total liabilities 550,000 55% Capital stock 200,000 20% Retained earnings 250,000 25% Total equity 450,000 45% Total liabilities and equity $1,000,000 100% The information provided by this balance sheet format is useful for noting changes in a companys investment in working capital and fixed assets over time, which may indicate an altered business model that requires a different amount of ongoing funding.