What is Vertical analysis (Common Size)?
Vertical Analysis (Common Size Statement) – Analysis of Financial Statements is done using three methods – Horizontal Analysis, Vertical Analysis and Ratio Analysis. In this article, we will discuss Vertical Analysis or the common size statement in detail.
Vertical analysis (Common Size) is a technique used to identify where a company has applied its resources and in what proportions those resources are distributed among the various balance sheet and income statement accounts. The analysis determines the relative weight of each account and its share in asset resources or revenue generation.
In the vertical analysis, each element of financial statements (Both Income Statement and Balance sheet) are shown as a percentage of another item. The assets, liabilities and share capital is represented as a percentage of total assets. In case of Income Statement, each element of income and expenditure is defined as a percentage of the total sales.
Vertical Analysis – Common Size of Balance Sheet
As an example of Vertical Analysis, let us take balance sheet of the Tata group companies as on 30.09.2016.
If we only look at the above balance sheet, it doesn’t make much sense.
Let me convert each and every element of this balance sheet as a percentage of “Total” which is 119,020 (common size of balance sheet). Then the balance sheet will appear as follows –
Now have a look at the above balance sheet. Looks much intuitive right? When we perform the vertical analysis, the data provides financial insights.
In this case, for making the common size of Balance Sheet, we converted all the elements of the balance sheet as a percentage of the total. –
On a standalone basis we can derive the following conclusions from the balance sheet:
- Reserves & surplus which is 58.3% is the highest portion. The company is having huge amount of reserves
- The debt to equity ratio in this company is (19.6÷1) = 0.33 which is low. That means that company is not using enough debt. The more debt brings the financial leverage and tax savings.
- Majority of reserves and a surplus portion is invested in non-current investments
- Most of the long-term borrowings are invested in the fixed assets.
- Company predominantly invested in Noncurrent investments than current investments.
- The company is a huge capital intensive company as an investment in non-current assets (Especially fixed assets is very high which is nearly 42.5%)
- Company trade receivables are 0.7% whereas trade payables are 5.6%. This means that company is not giving much credit to debtors whereas it is enjoying credit period from its creditors
As seen above, vertical analysis or common size statement can give you lot of better insights on the financial position of the company than when you look at the same otherwise.
Vertical analysis of financial statements over different periods
In continuation of the above common size example, let us now compare two-year balance sheets of the same company
Let us convert the same into percentage terms and derive some conclusions.
After conversion of the two years balance sheets, we can derive that
- Reserves marginally increased by 2% compared to 2015. This means profitability must have increased.
- Long-term borrowings have decreased by 1%, this means that some marginal repayments of loans must have happened.
- There is an increase in short-term borrowings by 1.7%.
- Inventory levels remained almost same.
- There is a marginal increase in trade receivables
- The share capital remained same that means there is no fresh issuance of capital.
Vertical Analysis – Common Size of Income Statement
Let’s go now perform common size of the Income Statement for different periods and analyze the same on the stand-alone period basis and for different years. Following is the P&L account of a Tata group company.
A plane looking at the above Income Statement might be confusing. So, let’s convert the same as a percentage of sales or Total income from operations. (Vertical Analysis of the Income Statement)
Following conclusions can be derived after converting the same as common size financial statements and comparing over different periods.
- There is a reduction in the purchase of finished, semi-finished steel and other products. As the percentage fell from 3.3% in Dec 2015 to 1.4% in Dec 2016.
- Raw material consumption at ~23% remains as per the past trend
- Employee cost reduced from 11% in Dec 2015 to 8.5% in Dec 2016
- Power cost too reduced from 6% to 5% in Dec 2016
- Total expenses reduced considerably from 91.5% in Dec 2015 to 82.2% in Dec 2016
- Tax expense increased three times from 1.6% in Dec 2015 to 4.2% in Dec 2016
On a standalone basis (I.e by analyzing a single period), following conclusions can be derived
- Raw material contributes to being the major cost in the process of manufacture which is nearly 23% of every sale.
- Net profitability margin of Dec 2016 period is 8.5%
- Since PBT is 12.7% and tax expense is 4.2% of sales, the company tax rate is around 30%
- The company has more closing stock than opening stock as Changes in inventories for Dec 2016 period is negative.
Vertical Analysis – Common Size of Colgate’s Income Statement
- In Colgate, we note that gross profit margin is in the range of 56%-59%.
- Selling General and administrative expenses decreased from 36.1% in 2007 to 34.1% in the year ending 2015.
- Operating income has dropped significantly in 2015.
- Net income decreased substantially to less than 10%.
- Effective tax rates jumped to 44% in 2015. Between 2008 to 2014, it was in the range of 32-33%.
Vertical Analysis – Common Size of Colgate’s Balance Sheet
- Cash and Cash equivalents increased from 4.2% in 2007 to 8.1% of the total assets.
- Receivables decreased from 16.6% in 2007 to 11.9% in 2015.
- Inventories decreased from 11.6% to 9.9% overall.
- Other current assets increased from 3.3% to 6.7% of the total assets over the last 9 years.
- On the liabilities side, Accounts payable currently stands at 9.3% of the total assets.
- There has been a significant jump in the Long Term Debt to 52,4% in 2015.
- Non controlling interests has also increased over the period of 9 years and is now at 2.1%
Advantages of vertical analysis
- Profit statements and other financial reports of different companies can be easily compared even though they are of different size. For example Balance sheet of Apple Inc and Samsung can be easily comparable after converting both into percentage terms.
- Within one company, annual or quarterly changes in the elements can be easily compared. For example Income statement of Apple Inc of different years can be comparable if the same is converted into a percentage. This gives a perfect indication of how much sales revenue improved or declined. How much each and every expense moved. How much depreciation expense increased or decreased.
- Promotes effective management decision making.
This has been a guide to what is Vertical Analysis or Common Size Statements and its advantages. Here we also discuss the common size of balance sheet and income statement along with practical examples of Tata and Colgate.
You may learn more about Financial Analysis from the following articles –