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.