COMMON SIZE

VERTICAL
ANALYSIS: A
TECHNIQUE
OF FINANCIAL
ANALYSIS
Introduction

Any business is started with the objective of earning profit. The going concern concept of the
firm says that the business is going to run for ever. For continuing the business, it is important
that cash cycle is completed every time it is initiated. There should always be cash available with
the company to enter into the next operating cycle. There should be least inventory of any type,
in order to keep the cash rotating. If there are credit sales, the receivables need to be converted
into cash fastly. An operating cycle would be called efficient if it ends with the same amount
with which it had started. Besides this short term capital the company also has long term capital.
The long term assets and long term liabilities and current assets and current assets and current
liabilities are shown in the four quadrants of the balance sheet of the company. Similarly, the
profit and loss account calculates the profit or loss position of the company. These statements are
also known as the final statements along with other statements. The stake holders of the business
are interested in knowing the position of business from the view point of financial health of the
business. Different stake holders want to analyze the financial statements from different angles.
Creditors want to know the financial stability of the organization. They would also like to know
credit worthiness of the organization. Similarly, other stake holders are interested in knowing
about the organization from their view point and their need. For this purpose, financial analysis
of financial statements is done. Financial Analysis is done using various techniques. Some
techniques of financial analysis are ration analysis, funds flow analysis, cash flow analysis,
common size statement analysis etc. In ratio analysis, various ratios are calculated to analyze the
financial health of the organization. Ratios are divided into different categories like activity
ratios, profitability rations, structural ratios and liquidity ratios, which are calculated as per the
requirement of the analyzer. In fund flow analysis, the flow of funds in the organization
throughout the year is analyzed. In cash flow analysis, the flow of cash is analyzed throughout
the year, in the organization. The objective of fund flow analysis and cash flow analysis is to
know the direction of inflow and outflow of funds and cash respectively. Yet another useful
technique of financial analysis is common size statement analysis. Through common size
statement analysis, one comes to know the comparative picture of various entities in balance
sheet and profit and loss account.

Financial analysis

Financial analysis is the process of performing financial SWOT analysis of the firm. The basis of
financial analysis is the financial statements of the company. The items present in the balance
sheet and profit and loss account of the company and their inter relations form the base for
financial analysis. Financial analysis is diagnostic in nature. It tries to find out the areas where
the company is financially sound and the areas where the company is not able to perform up to
the mark. Financial analysis is useful in finding and analyzing much information related to the
items contained in the balance sheet and profit and loss account of the company. Financial
analysis of the company is useful to the internal as well as external stake holders of the company.
The parties inside to the company who are interested in financial analysis are the management,
the owners, the employees etc. Outsiders who would be interested in financial analysis of the
company are the creditors, banks, financial institutions or other suppliers of short term and long
term funds, investors, equity share holders, government agencies, tax department, registrar of
companies etc. The type and nature of financial analysis depends upon the purpose of the user of
the information. Most common objectives of financial analysis are to find out short term liquidity
of the firm, to find out long term financial stability of the firm, to find out proportion of debt and
equity in the capital structure of the company, to find out gross and net profitability of the
company, to find earnings per share and dividend per share etc. The objective of financial
analysis purely depends upon the utilization purpose of the user. Financial analysis is helpful in
finding if the business can run in long term or not as financial analysis helps in examining the
turnover of various items in the balance sheet and the profit and loss account of the company.
The tools of financial analysis include ratio analysis, cash flow analysis, fund flow analysis,
common size statement analysis, trend analysis etc. each technique has different utility. Common
size statement is a simple technique of financial analysis. Financial analysis can be done on
either internal or external basis. The persons who have access to the internal documents of the
company would perform internal analysis and those who cannot access the internal information
of the company would perform external analysis. It is evident that internal users perform internal
analysis and external users do external analysis.

Internal Users External Users

Management - Uses financial analysis to assess
the company's performance, set goals, make
strategic decisions, and allocate resources
effectively.
Employees - Use financial information to
understand the company's financial health,
stability, and future prospects, which can impact
job security and performance.
Shareholders - Analyze financial data to
evaluate the company's profitability, growth
potential, and overall value, helping them make
investment decisions.
Investors - Use financial analysis to assess the
company's financial health and growth
prospects before making investment decisions.
Creditors - Evaluate the company's financial
position to determine its creditworthiness and
assess the risk of lending money to the
organization.
Regulatory bodies - Use financial information
to ensure compliance with accounting
standards, regulations, and reporting
requirements.
Customers - May analyze a company's financial
stability and performance to assess its ability to
fulfill orders and provide long-term support for
products or services.
Suppliers - Assess a company's financial
stability to evaluate credit terms and assess the
risk of doing business with the organization.
Competitors - Use financial analysis to
benchmark their performance against industry
peers and identify areas for improvement or
competitive advantage.

Common size statement

Common size statement is a simple technique of financial analysis. In a common size statement,
the items in the balance sheet and profit and loss account are brought on a common platform by
finding their percentages with respect to the total of the column. Common size statements if
prepared for a single firm for consecutive years, give an idea about the changes in the figures of
various items of the balance sheet and the profit and loss account. Common size statement
immediately reflects any changes in the items of balance sheet and the profit and loss account. In
common size statement, the rupee amount is mentioned in percentage terms. Common size
statements are effective for depicting relative changes in different items. Common size
statements are very much useful in inter firm comparison of financial comparison. These can also
be used to compare two firms with in an industry or two firms from two different industries.
Thus, common size statement analysis is not only useful in intra firm comparison but it is also
useful in inter firm comparison. Common size statements are also useful in comparison between
two time periods. This makes the financial analysis more effective.

Preparation and analysis of Common Size Statement

Common size statements are easy to prepare and comprehend. To prepare common size
statement, the balance sheet and the profit and loss account of the company are needed.

COMMON-SIZE VERTICAL ANALYSIS OF BALANCE SHEETS

Another technique used to analyze balance sheet information is to convert the statement to a
common-size vertical analysis format. This method requires only one period of financial data.
Common size means that total assets have a value of 100 percent and the numerical value of each
item being converted represents a fractional part of total assets. Since Assets = Liabilities +
Owner’s Equity and each side of the balance sheet has the same total value, every item in a
balance sheet, subtotals, and totals, can be expressed as a percentage of total assets.

The illustration above shows the common-size (vertical). The common-size statement shows that
the cash account in Year 0003 is 1.6 percent of total assets, which was calculated by dividing the
cash balance by total assets; $22,900 / $1,448,800. Accounts payable in Year 0003 is 1.3 percent
of total assets, $19,200 / $1,448,800. Each balance sheet item shown for Year 0003 is divided by
total assets of Year 0003. The addition of each item percentage shown for Year 0003 will equal
100 percent, which is the product of total assets divided by total assets.
Any subset of a balance sheet such as current assets, fixed assets, current liabilities, long-term
liabilities, or ownership equity can be converted to a common-size vertical format and analyzed
separately. Since each current liability is a part of total current liabilities, a common-size vertical
analysis of current liabilities will express each individual current liability as a percentage of total
current liabilities. As an example, we will use the current liability accounts above to express each
as a percentage of total current liabilities.
Accounts Payable + Accrued Expense + Income taxes payable + deposits and credit
balances + Current portion of mortgage = Current Liabilities
$19,200 = n1 + $3,500 = n2 + $12,300 = n3 + $500 = n4 + $27,300 = n5 = $62,700 = ∑n
The common-size vertical analysis can be described using the equation: n1+ n2 + n3 ... nx =
∑n. Each element, n1, n2, and n3 is divided by the sum, ∑n, to find its percentage relationship;
n1 / ∑ n identifies what percentage n1 is of ∑n.
Thus,
[n1/∑n] = $19,200 / $62,700 × 100 = 30.6%
[n2/∑n] = $3,500 / $62,700 × 100 = 5.6%
[n3/∑n] = $12,300 / $62,700 × 100 = 19.6%
[n4/∑n] = $500 / $62,700 × 100= 0.8%
[n5/∑n] = $27,300 / $62,700 × 100= 43.4%

Regardless of whether you are converting a balance sheet or a subset of assets, liabilities, or
ownership equity, the conversion procedure is the same. The advantage of common-size
statements is that they show changes in proportion of individual accounts from one period to the
next. For example, the cash account in Year 0003 was 1.6 percent of total assets. In Year 0004, it
was 2.5 percent of total assets. This change in proportion would normally attract reader’s
attention and raise questions. Attention might also be drawn to other accounts where large
changes have occurred. The common-size vertical analysis technique is particularly useful when
comparing two companies whose size and/or level of business are very different so other
techniques of analysis are not appropriate.
Whether a hotel or food service operation uses comparative balance sheets or common-sized
balance sheets is a matter of choice. Normally, only one or the other would be preferred since
both draw the attention of the reader to the relevant accounts where changes have occurred.
However, sometimes one technique will identify changes that other techniques did not indicate.
Identifying changes should provoke questions, the answers to which may be helpful in running
the business more effectively. Attention should be focused on the balance sheet because of the
need for effective control or management of a company’s assets. However, as a management
technique for controlling internal day-to-day operations, comparative income statements are
often more useful than comparative balance sheets.

COMMON-SIZE VERTICAL ANALYSIS OF INCOME STATEMENTS

Income statements can also be converted to a common-size vertical analysis format. With the
conversion of the income statement, total sales revenue takes the value of 100 percent and all
other items on the income statement are expressed as a fraction of total sales revenue. However,
for the cost of sales, the cost of each product is divided by its respective sales revenue.
Therefore, the cost of sales–food is divided by food sales revenue and the cost of sales–beverage
is divided by beverage sales revenue. A common-size income statement is illustrated below. For
example, in Year 0003 dining room sales revenue was ,23.7 percent of total sales revenue and is
calculated as follows:
Dining sales revenue / Total Sales Revenue = % of Total Sales Revenue
$201,600 / $851,600 = 23.7%
All items except the cost of sales in Exhibit 3.4 are calculated the same way, using $851,600 as
the denominator and the individual item as the numerator. Note that the percentage given for
gross profit is a nonaccount subtotal and cannot be included to arrive at the 100 percent total of
the other items’ percentages. Gross profit (also called gross margin) is a derived subtotal
representing sales revenue minus cost of sales and does not represent an operating cost, nor does
it represent the resulting profit or loss from operations.
Expense items, except the cost of sales, also use $851,600 as the denominator for Year 0003. For
example, the cost of salaries and wages would be calculated as follows:
($277,500 / $851,600) × 100 = 32.6%
However, net food cost is calculated as follows for Year 0003:
[ $289,500 / ($851,600 - $111,200)] × 100 = 39.1%
One way of interpreting the common-size income statement information in Year 0003 is to say
that, out of every $1.00 of sales revenue, 37.9 cents was for total cost of sales, 32.6 cents was for
salaries and wages, 4.1 cents was for employee benefits, and 7.6 cents was for all other operating
expenses, leaving only 18.0 cents for income. In Year 0004, this income was down to 13.3 cents
out of every $1.00 of revenue. Common-size income statements show which items, as a
proportion of revenue, have changed enough to require investigation.
For example, one of the causes for the decline to 13.3 cents of departmental income from each
dollar of sales revenue in Year 0004 is that the amount spent on total cost of sales has risen from
37.9 cents to 39.3 cents out of each dollar of sales revenue. This 1.4-cent increase might seem
insignificant, but if it had not occurred, we would have made $12,167 more income, calculated
as follows:
$869,100 × 1.4% = $12,167
In the interest of brevity in illustration, a number of expenses have been added together under
“all other operating expenses.” In Year 0003, this figure is 7.6 percent of revenue, and in Year
0004, 8.0 percent of revenue. This is a relatively small change and might normally be unnoticed.
It is small only because several of the individual items that decreased offset many of the
individual expense items that increased, thus hiding the facts. In practice, it would be best to
detail each individual expense and express it as a percentage of revenue to have full information.
The income statement illustrated for the food operation was analyzed with both comparative
horizontal and common-size vertical methods. Normally, only one or the other would be used.
They each draw attention, albeit in a different way, to problem areas requiring investigation, and,
if necessary, corrective action. However, sometimes one technique will identify problems that
should be investigated that the other technique may not indicate. Therefore, sometimes it is a
good idea to complete both a comparative and common-size vertical analysis.
Note again that the common-size vertical analysis method is the more appropriate one to use
when comparing two companies whose size or scale of operation is quite different. There is one
other method of horizontal comparative analysis particularly suited to the food operation, and
that is to calculate and compare average sales revenue per guest, average cost per guest, and
average income per guest information.
Conclusion

Financial analysis is an important activity carried on by different stake holders of any company.
The purpose of financial analysis by different stake holders is different. Creditors do financial
analysis with the objective of analyzing payment capacity of the company. These are interested
in knowing the liquidity position of the company. Management is interested finding out the
efficiency with which the funds are being utilized. Owners are interested in analyzing the
profitability of the company. Similarly, the other stake holders have their own specific objectives
of financial analysis. Financial analysis can be done using various techniques like ratio analysis,
cash flow analysis, fund flow analysis, trend analysis, common size statement analysis etc. The
choice of method depends upon the purpose of analysis. Common size statement analysis is a
simple and effective technique of analysis of income statement and balance sheet of the
company. In common size statement, al items of income statement and balance sheet are brought
on common platform by calculating percentages of these items to the total of that particular head.
Percentages make the comparison simple and comprehensive. Common size statement analysis is
helpful in comparison of data pertaining to two accounting years of the same company or for the
same accounting year of two different companies from the same industry or two different
companies from different industries. Common size statement analysis is helpful in finding out
the changes in various items of income statement and balance sheet. This analysis further helps
the stake holders in understanding the financial position and condition of the company. Though
different stake holders have distinct motive for common size statement analysis, the statement is
represented as percentages if different items to the group total. This analysis is very useful to
various stakeholders in understanding the company from the view point of financial performance
and liquidity.