RCMA 4: Vertical Analysis | Phoenixnotebook

Basic Financial Statement Analysis

Common-Size Financial Statement Analysis ( Vertical Analysis)

Objectives:

Understand Common-Size Financial Statement Analysis.
Learn to perform Common-Size Analysis on income statements and balance sheets.
Interpret results.
Recognize advantages and limitations.
Apply Common-Size Analysis for informed decision-making.

Common-Size Financial Statement Analysis (Vertical Analysis) is a powerful tool utilized by financial managers to assess a company's financial performance. This method evaluates financial statements by expressing each line item as a percentage of a base amount for that period. For instance, to analyze the cost of goods sold (line item) relative to revenue (base item), you would divide the cost of goods sold by the revenue.

One of the significant benefits of common-size analysis is its ability to allow investors to identify significant changes in a company's financial statements. By expressing each line item as a percentage of a base figure, such as total revenue or total assets, it becomes easier to spot trends, anomalies, and areas of concern or improvement. Moreover, common-size analysis facilitates the comparison of companies of different sizes. This comparative analysis provides valuable insights into the relative financial structures and performances of companies operating within the same industry or sector.

The base amount is set at 100%. All of the other line items on the financial statement are calculated as a percentage of the base amount. The formula is:

Amount of the Line Item

Percentage of Base = ______________________ x 100

Amount of the Base

ILLUSTRATION 1: Income Statement Common Size Analysis

The base item in the income statement is usually the total sales or total revenues. Common size analysis is used to calculate net profit margin, as well as gross and operating margins.

Calculating Percentages Examples:

Cost of Goods Sold (COGS) in Year 1:

COGS Percentage = (Cost of Goods Sold / Net Sales) * 100%
COGS Percentage = ($200,000 / $400,000) * 100% = 50%

Cost of Goods Sold (COGS) in Year 2:

COGS Percentage = (Cost of Goods Sold / Net Sales) * 100%
COGS Percentage = ($150,000 / $500,000) * 100% = 30%

Interpretation:

The decrease in COGS from 50% to 30% between Year 1 and Year 2 indicates successful efforts to cut production costs, enhance supplier deals, or refine inventory management. This improvement in cost efficiency led to higher profitability and larger gross profit margins, signifying improved operations and a stronger ability to generate profits from sales revenue.

Net Income in Year 1:

Net Income Percentage = (Net Income / Net Sales) * 100%
Net Income Percentage = ($80,000 / $400,000) * 100% = 20%

Net Income in Year 2:

Net Income Percentage = (Net Income / Net Sales) * 100%
Net Income Percentage = ($245,000 / $500,000) * 100% = 49%

Interpretation:

The rise in net income percentage from 20% in Year 1 to 49% in Year 2 reflects a significant enhancement in the company's profitability. This improvement suggests successful strategies or operational efficiencies implemented, indicating the company's strengthened financial performance and increased ability to generate profits from sales revenue.

ILLUSTRATION 2: Balance Sheet Common Size Analysis

The balance sheet common size analysis mostly uses the total assets value as the base value. A financial manager or investor can use the common size analysis to see how a firm’s capital structure compares to rivals. They can make important observations by analyzing specific line items in relation to the total assets.

Calculating Percentages Example:

Long-Term Debt

Long-Term Debt Percentage = (Long-Term Debt / Total Assets) * 100%
Long-Term Debt Percentage = ($36,000 / $100,000) * 100% = 36%

Interpretation:

A high Long-Term Debt percentage of Total Assets, like the calculated 36%, suggests potential financial distress for the company. This implies heavy reliance on long-term borrowing, raising concerns about financial stability and flexibility. Stakeholders should closely monitor these ratios to ensure the company's financial health and resilience.

Advantages and Disadvantages of Vertical Analysis:

Advantages:

Normalizes data for comparison: By expressing each line item as a percentage of a base figure, such as total revenue or total assets, vertical analysis allows for easier comparison of companies of different sizes.
Identifies trends over time: Vertical analysis helps in identifying trends within a company's financial statements over multiple periods, facilitating trend analysis and forecasting.
Highlights risk exposure: It can help highlight areas where a company may be overexposed to risk by comparing the proportion of different items, such as expenses or liabilities, to total revenue or assets.

Disadvantages:

Difficulty in comparing across industries: Companies in different industries may have vastly different financial structures, making it challenging to compare them effectively using vertical analysis.
Focuses on relative values only: Vertical analysis does not consider absolute values, which means that two companies with the same percentage change in an item may have significantly different actual financial impacts if one company started with a much higher absolute value.

PRACTICE EXERCISES

Vertical analysis is a technique that expresses each item in a financial statement

a) in dollars and cents

b) as a percent of the item in the previous year.

c ) as a percent of a base amount.

d) starting with the highest value down to the lowest value

2. The purpose of financial analysis.

a) To help the users of financial statements make better business decisions.

b) Internal users want to make decisions that improve the company's and product/service efficiency

c) To evaluate the company's financial position and future performance along with possible risks.

d) All of the above

3. All of the following are included in the balance sheet, except one

a) Cost of goods sold

b) Accumulated depreciation

c) Prepaid rent

d) Retained earnings

When an accountant calculates different parts of a financial statement in terms of a percentage of the total amount, the accountant is doing a _____.

a) Percentage analysis

b) Income analysis

c) Vertical analysis

d) Horizontal analysis

Vertical analysis is typically performed on what financial statements?

a) Balance sheets and retained earnings statements

b) Tax forms and income statements

c) Income statements and retained earnings statements

d) Balance sheets and income statements

For items 6-8

Jan, Inc. had the following information:

6. Using vertical analysis for Year 1, what is the percentage of cost of goods sold and net income, respectively?

a) 66.2% and 22.9%

b) 66.2% and 10.8%

c) 22.9% and 10.8%

d) 10.8% and 66.2%

7. Find the percentage of cost of goods sold for years 2 & 1?

a) 66.2% and 22.9%

b) 16% and 62%

c) 66.2%% and 16%

d) 62% and 66.2%

8. Calculate the net income percentage for Year 2.

a) 22%

b) 35%

c) 44%

d) 56%

9. If a business has P100,000 in total assets, which includes P35,000 cash, P10,000 in inventory, and P55,000 in accounts receivable, what is the vertical analysis of total assets?

a) Cash 35% inventory 10%, and accounts receivable is 55%

b) Cash 15% inventory 10%, and accounts receivable is 45%

c) Cash = 20% inventory = 35%, and accounts receivable is 25%

d) Cash = 15% inventory = 40%, and accounts receivable is 35%

10. A company has total assets of P4,525,000 and accounts receivable valued at P 425,000 Accounts receivable is what percent of total assets?

a) P125,000

b) 3.5%

c) 911%

d) 9.39%