Common Size Statements – Vertical Analysis

Contents of this page are divided into following headings.

• What are Common Size Statements?
• What are Vertical Analysis / Method?
• Example of Vertical Analysis
• Interpretation of Vertical Analysis

For readers who have already read the Horizontal Analysis, I Will suggest skipping 1. what are / importance of common size statements?

Importance of Common Size Statements

In order to evaluate the position of the company, company’s performance and its assets are compared with other companies operating in the same industry. However these comparisons are worthless since companies operating in the industry can be small, medium or big. This can be better understood by an illustration.

Suppose company A & B have earned profits \$500 and \$1,000 respectively. Which company is more profitable? Company B seems to be profitable in this simple comparison. However Company A is a small company with \$500 total assets; on the other hand Company B is big company with \$5,000 total assets. If ratio of earnings with respect to total assets is taken; then Company A’s returns are \$1 whereas company B’s return are \$0.2. Which company is more profitable? Obviously Company A is more profitable.

Therefore the need to convert the financial statements into Common Size (note words “common size”) is necessary for accurate comparisons. Vertical and Horizontal analysis are the techniques of converting financial statements into common size for comparison purposes. Details of vertical analysis are provided below, for horizontal analysis please see the next page.

Vertical Analysis Method

In vertical analysis financial statements are converted into common size by taking a figure as base and then showing all figures as the percentage of that figure in vertical direction (see example below).

STEP1: In Statement of Financial Position: “Total assets” are taken as the base figure and all the assets & liabilities are presented in percentages of total assets.

STEP2: In statement of Comprehensive Income: “Total Sales” are taken as the base figure and all the incomes and expenses are presented in the percentages of total sales.

STEP3: Check the accuracy (this is optional)

• In case of statement of financial position, by adding entire assets percentages or entire liabilities (including Equity) percentages; this should be equal to 100%.
• In case of statement of comprehensive income, by adding entire expenses & incomes percentages and profit after tax percentage; this should be equal to 100%.

Since all figures are vertical to base figure thus the name vertical analysis is used. This will be more clearly evident from the following example.

Example

The hypothetical Statement of comprehensive income is shown below. Let’s convert this into common size statement.
ABC LIMITED
Statement of Comprehensive Income
For the year ended 31 December 20XX
(This illustrative set of financial statements seeks to provide guidance for financial analysis).

 20XX 20X0 \$ \$ Revenue 7,468,110 7,016,215 Cost of sales (3,866,710) (2,853,835) Gross Profit 3,601,400 4,162,380 General andAdministrative Expenses (2,250,875) (2,341,339) Otheroperatingexpenses (450,175) (780,446) Profit /Loss fromOperating Activities 900,350 1,040,595 Finance costs (3,485) (13,400) Other income 385 448 Profit before tax 897,250 1,027,643 Taxation (333,150) (385,048) Profit after tax 564,100 642,595

STEP 1: First of all highlight the BASE FIGURE which is “Sales” in this case amounting to \$7,468,110 and \$ 7,016,215 respectively for year 20XX and 20X0.

STEP 2: Divide each figure presented in statement with sales figure and write the answer in percentages e.g. costs of sales (3,866,710 / 7,468,110)*100 = 51.78%.

STEP 3: CHECK (optional). Check the accuracy of conversion by adding the entire individual expenses & incomes percentages which should be equal to 100% i.e. cost of sales +general and administrative expenses + other operating expenses + finance costs + other income + taxation + Profit after tax.

That’s all. Now the statement is common sized and can be compared with other companies’ common size statements and with its own previous years’. See interpretation of vertical analysis for more information.

The common size statement will look like this.

ABC LIMITED
Statement of Comprehensive Income
For the year ended 31 December 20XX
Common Sized

 20XX 20X0 \$ \$ Revenue 100% 100% Cost of sales 52% 41% Gross Profit 48% 59% General andAdministrative Expenses 30% 33% Otheroperatingexpenses 6% 11% Profit /Loss fromOperating Activities 12% 15% Finance costs 0.05% 0.19% Other income 0.01% 0.01% Profit before tax 12% 15% Taxation 4% 5% Profit after tax 8% 9%

Check (optional): 52% + 30% +6% +0.05% + 0.01% + 4% + 8% = 100.06% (0.06 rounding off difference).

Interpretation of Vertical Analysis

Vertical analysis provides useful insights about the performance of the company by taking into consideration various components of the company. Vertical Analysis can be interpreted as internal comparison and external comparison.

Internal Comparison:

In the above example cost of sales were 52% of total sales. Similarly, General and Administrative expenses are 30% of total sales.
Company has not performed very well in controlling cost of sales expenses as it were 41% last year and increased in current year by 11% (to 52%). Company need to recheck its cost of sales controls.

On the other hand company has performed better in reducing other operating expenses which are now only 6% as compared to last years of 11%.
Finance costs has reduced from last year but we can clearly see that finance cost is not a major expense and therefore do not impact much on current year’s performance. This also indicates that either the company’s borrowings are low or is capitalized in some other assets of the company.

By comparing vertically (thus the name vertical analysis) we have extracted meaningful information about the performance of the company. Statement of financial position is interpreted in the same manner.

External Comparison:

In external comparison the performance of the company is compared with other companies or industry averages. For example 52% cost of sales is compared with industry average which suppose is 40%, then definitely company is not performing well and company should seriously take into account the measures for its cost of sales and vice versa.

Horizontal Analysis is discussed on previous page.

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