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Study Pack 35 (B) Vertical Analysis & Common Sized Statements

The exam will consist of multiple choice questions covering both financial accounting and elementary analysis of financial statements. Sometimes it can be difficult to interpret in a meaningful way all the dollar amounts presented in a set of financial statements. For example, if one company has liabilities of $10,000 and another company has liabilities of $10,000,000; is the first company less risky? Maybe or maybe not, it depends in part on the size of the company [how much in assets does each company have?] and the companys industry. A useful way to analyze financial statements is to perform either a horizontal analysis or a vertical analysis of the statements. These types of analysis help a financial statement reader compare companies of different sizes, which can be difficult to do when the dollar amounts vary significantly, and evaluate the performance of a company over time. The horizontal and vertical analysis approaches are similar in that the dollar amounts reported are converted to percentages. However, the approaches differ in the base used to compute the percentages. Vertical Analysis Overview Vertical analysis is the proportional analysis of a financial statement, where each line item on a financial statement is listed as a percentage of another item. Typically, this means that every line item on an income statement is stated as a percentage of gross sales, while every line item on a balance sheet is stated as a percentage of total assets. The most common use of vertical analysis is within a financial statement for a single time period, so that you can see the relative proportions of account balances. Vertical analysis is also useful for timeline analysis, where you can see relative changes in accounts over time. For example, if the cost of goods sold has a history of being 40% of sales, then a new percentage of 48% would be a cause for alarm. Common Size Financial Statement Analysis Common Size Statement involves representing the income statement figures as a percentage of sales and representing the balance sheet figures as a percentage of total assets. Financial statements represent absolute figures and a comparison of absolute figures can be misleading. For example, the cost of goods sold might have increased but as a percentage of sales it might have decreased. So, to have a perfect understanding about these increases and decreases, the figures reported are converted into percentages to some common base. In Income Statement, Sales figure is assumed to be 100% and all other figures are expressed as a percentage of sales. In Balance Sheet, the total of assets is taken as 100% and all other figures are expressed as a percentage of total assets. This type of Statement so prepared is called as the Common Size Statement and the analysis performed on the Common Size Statement is called as the Common Size Financial Statement Analysis or otherwise called as Vertical Analysis. Example of Common Size Income Statements for ABC Corp for the years ended 31st Dec 2011 & 31st Dec 2012 where the $s are expressed solely as a % of sales ( To the right is the a comparison of the Income Statement Sheet and a Common Sized one) ABC Corp
Common Size Income Statements Year ended 31st Dec 2011 & 2012 2011 100.00% 71.43% 28.57% 2.86% 5.71% 1.43% 18.57% 4.29% 14.29% 2012 100.00% 71.11% 28.89% 3.33% 5.56% 1.67% 18.33% 4.44% 13.89%

XYZ Corp Income Statement& Common Sized

Sales Less: Cost of goods sold Gross profit Less: Operating expenses General & administrative expenses Selling & distribution expenses Other operating expenses Operating profit Less: Interest expenses Net income before taxes

Less: Taxes at 30% Net Income after taxes

4.29% 10.00%

4.17% 9.72%

Example of Common Size Balance Sheet for the years ended 31st Dec 2011 & 31st Dec 2012 where the $s are expressed solely as a % of Total Assets (On the right is a Balance Sheet and Common Sized one.)

ABC Corp
Common Size Balance Sheets as on 31st Dec 2011 & 2012
2011 Current Assets: Cash Accounts Receivables Inventory Total Current Assets Non Current Assets: Buildings Computer & Office Equipments Total Non Current Assets Total Assets Liabilities: Current Liabilities: Accounts Payable Notes Payable Interest Payable Total Current Liabilities Shareholder's Equity: Common Stock Retained earnings Total Stockholder's equity Total Liabilities & Stockholder's equity 6.25% 25.00% 18.75% 50.00% 37.50% 12.50% 50.00% 100.00% 2012 5.17% 25.86% 21.55% 52.59% 34.48% 12.93% 47.41% 100.00%

XYZ Corp Balance Sheet & Common Sized

12.50% 6.25% 1.25% 20.00% 62.50% 17.50% 80.00% 100.00%

10.34% 4.31% 1.03% 15.69% 64.66% 19.66% 84.31% 100.00%

What is the difference between Vertical & Horizontal Analysis Vertical analysis reports each amount on a financial statement as a percentage of another item. For example, the vertical analysis of the balance sheet means every amount on the balance sheet is restated to be a percentage of total assets. Horizontal analysis looks at amounts on the financial statements over the past years. For example, the amount of cash reported on the balance sheet at December 31 of 2006, 2005, 2004, 2003, and 2002 will be expressed as a percentage of the December 31, 2002 amount. Instead of dollar amounts you might see 134, 125, 110, 103, and 100. This shows that the amount of cash at the end of 2006 is 134% of the amount it was at the end of 2002. The same analysis will be done for each item on the balance sheet and for each item on the income statement. This allows you to see how each item has changed in relationship to the changes in other items. Horizontal analysis is also referred to as trend analysis. Vertical analysis, horizontal analysis and financial ratios are part of financial statement analysis. Student Exercise: Re State the Balance Sheet and Income Statement for 2012 based on Normal/Standard basis of ABC Corp above given to the following information: Total Assets were $2,500,000 Total Sales $5,000,000 NOTE: You should create the Income Statement as a Standard and the Balance Sheet as a Normal