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%.

Example:

Balance Sheet:

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:

Common Size Comparative Balance Sheet       December 31, 2002, and 2001      (dollars in thousands)
			Common-Size Percentages
	2002	2001	2002	2001
Assets
Current assets:
Cash	$ 1,200	$ 2,350	3.8%	8.1%
Accounts receivable, net	6,000	4,000	19.0%	13.8%
Inventory	8,000	10,000	25.4%	34.5%
Prepaid expenses	300	120	1.0%	0.4%
	------------	------------	-----------	------------
Total current assets	15,500	16,470	49.2%	56.9%
	------------	------------	------------	------------
Property and equipment:
Land	4,000	4,000	12.7%	13.8%
Building and equipment	12,000	8,5000	38.1%	29.3%
	------------	------------	------------	------------
Total property and equipment	16,000	12,500	50.8%	43.1%
	------------	------------	------------	------------
Total assets	$ 31,500	$ 28,970	100.0%	100.0%
	======	======	======	======
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable	$ 5,800	$ 4,000	18.4%	13.8%
Accrued payable	900	400	2.9%	1.4%
Notes payable, short term	300	600	1.0%	2.1%
	------------	------------	------------	------------
Total current liabilities	7,000	5,000	22.2%	17.3%
	------------	------------	------------	------------
Long term liabilities:
Bonds payable, 8%	7,500	8,000	23.8%	27.6%
	------------	------------	------------	------------
Total liabilities	14,500	13,000	46.0%	44.9%
	------------	------------	------------	------------
Stockholders' equity:
Preferred stock, $100, 6%, $100 liquidation value	2,000	2,000	6.3%	6.9%
Common stock, $12 par	6,000	6,000	19.0%	20.7%
Additional paid in capital	1,000	1,000	3.2%	3.5%
	------------	------------	------------	------------
Total paid in capital	9,000	9,000	28.6%	31.1%
Retained earnings	8,000	6,970	25.4%	24.1%
	------------	------------	------------	------------
Total stockholders equity	17,000	15,970	54.0%	55.1%
	------------	------------	------------	------------
	$ 31,500	$ 28,970	100.0%	100.%
	======	======	======	======

*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: 
[$1,200 /  $31,500 = 3.8%]

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.

Income Statement:

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:
 

Common-Size Comparative income statement For the year ended December 31, 2002, and 2001 (dollars in thousands)
			Common-Size Percentage
	2002	2001	2002	2001
Sales	$52,000	$48,000	100.0%	100.0%
Cost of goods sold	36,000	31,500	69.2%	65.6%
	------------	------------	------------	------------
Gross margin	16,000	16,500	30.8%	34.4%
	------------	------------	------------	------------
Operating expenses:
Selling expenses	7,000	6,500	13.5%	13.5%
Administrative expense	5,860	6,100	11.3%	12.7%
	------------	------------	------------	------------
Total operating expenses	12,860	12,600	24.7%	26.2%
	------------	------------	------------	------------
Net operating income	3,140	3,900	6%	8.1%
Interest expense	640	700	1.2%	1.5%
	------------	------------	------------	------------
Net income before taxes	2,500	3,200	4.8%	6.7%
Income tax (30%)	750	960	1.4%	2.0%
	------------	------------	------------	------------
Net income	$ 1,750	$2,240	3.4%	4.7%
	======	======	======	======

*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:
[($36,000 / $52,000) × 100  = 69.2%]

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.