Chapter 13: Vertical Analysis

Vertical Analysis: Definition and Application Vertical Analysis, also known as common-size analysis, is a method used to analyze financial statements by expressing each item as a percentage of a base amount within the same statement. This helps in understanding the relative size or significance of different financial statement components and allows for easier comparison across periods or with other companies, regardless of size. Methods of Vertical Analysis 1. Common-Size Statements: o Common-Size Financial Statements express each line item as a percentage of a total, making it easier to see the relative proportion of different components. o Base Amount:  On the income statement, the base amount is total revenue (net sales), which is assigned a value of 100%. All other income statement items are expressed as a percentage of this total revenue.  On the balance sheet, the base amount is total assets, also assigned a value of 100%. Each asset, liability, and equity item is then shown as a percentage of total assets. 2. Common-Size Percent Calculation: o The formula for calculating a common-size percent is: CommonSize Percent=(Analysis AmountBase Amount)×100 o For example, if a company’s total assets are $1,000,000 and its cash balance is $100,000, the common-size percentage for cash would be: (100,0001,000,000)×100=10% Application of Vertical Analysis 1. Common-Size Balance Sheets: o Vertical analysis of balance sheets helps assess the composition of a company’s assets, liabilities, and equity. o For example, if total assets are $500 million, and cash makes up $50 million, then cash represents 10% of total assets. o This method can identify significant changes in the structure of a company’s balance sheet. For instance, an increase in cash and short-term investments might indicate a shift toward greater liquidity, while a decline in long-term assets could suggest changes in investment strategy. 2. Common-Size Income Statements: o Analyzing income statements using vertical analysis helps understand how revenue is distributed across different costs and expenses. o For example, if Apple’s total sales are $100 billion, and cost of goods sold (COGS) is $60 billion, then COGS represents 60% of sales. This means that for every dollar Apple earns in revenue, $0.60 goes to covering the cost of goods. o This allows comparison of expense structures across periods or against other companies, highlighting changes in costs relative to revenue. 3. Interpreting Results of Vertical Analysis: o Identify Trends: By comparing common-size statements over multiple periods, one can detect trends in the allocation of expenses or asset composition. o Evaluate Efficiency: A lower percentage for operating expenses relative to sales can indicate improved operational efficiency. o Strategic Shifts: Changes in the relative weight of assets or liabilities can indicate shifts in company strategy, such as a move toward short-term investments. Example of Vertical Analysis Let’s consider Apple Inc. using a common-size balance sheet: • • Increase in Cash and Cash Equivalents: If cash and cash equivalents increase from 5% to 10% of total assets, it suggests a focus on maintaining liquidity, potentially to support future investments or meet short-term obligations. Decrease in Long-term Investments: A reduction in long-term marketable securities, from 20% to 15% of total assets, might indicate that Apple is divesting or allowing certain securities to mature without reinvesting in long-term holdings. Similarly, on a common-size income statement: • • Research and Development Costs: If R&D expenses increase from 7% to 8% of net sales, it might indicate a strategic focus on innovation and product development, even if overall revenue remains stable. Tax Expense Reduction: A decrease in tax expense from 5% to 3% of net sales could reflect changes in tax legislation or a shift in how the company manages its tax liabilities. Visualization in Vertical Analysis • Data Visualizations: Tools like pie charts, bar graphs, or segment analysis provide a visual representation of common-size data, making it easier to grasp changes in proportions. o Example: A pie chart of Apple’s income statement might show how much of each dollar of sales goes to COGS, operating expenses, and net income. o Segment Analysis: By visualizing the common-size income statement or balance sheet across different business segments, analysts can identify which segments contribute the most to overall profitability or where cost structures differ. Benefits of Vertical Analysis • • • Comparative Analysis: Vertical analysis allows easy comparison with competitors and industry benchmarks. For example, if Apple’s COGS as a percentage of sales is significantly lower than the industry average, it might indicate better cost management. Time-Series Analysis: It is effective in highlighting how internal changes impact the relative structure of financial statements over time, helping management assess strategic decisions’ effects. Decision-Making: Understanding the relative weight of different expense categories aids in budgeting and forecasting, as managers can identify areas that may need adjustment. Summary Vertical Analysis is a powerful method for evaluating the relative importance of individual items in financial statements by expressing them as percentages of a base figure. It provides insights into a company's cost structure, asset distribution, and overall financial strategy. By using common-size balance sheets and income statements, analysts and managers can make informed comparisons and identify trends, leading to better financial decisions.