Common size financial statement analysis, also called vertical analysis, is just one technique that financial managers use to analyze their financial statements. It is not another type of income statement. It is just a tool that is used to analyze the income statement. Common size income statement analysis is stating every line item on the income statement as a percentage of sales. If you have more than one year of financial data, you can compare income statements to see your financial progress. This type of analysis will let you see how the revenues and the spending on different types of expenses change from one year to the next.
When you show the items of the income statement as a percentage of sales figure, it is easy to compare the income and expenses and understand the financial position of the company. Common size analysis is an excellent tool to compare companies of different sizes or to compare different years of data for the same company, which is what we are doing in this example. Common size analysis is not as detailed as trend analysis using ratios. It does not provide enough data for sophisticated investing decisions. For managers of small businesses who do not have a lot of formal education in financial management, vertical analysis provides a simple way for them to analyze their financial statements.
Analysis of Revenue for XYZ, Inc.
The two income statements in the table below, for XYZ, Inc., are for 2011 and 2012. Let's take a look and see how XYZ, Inc. did over these two years.
First, we see that sales increased from 2011 to 2012, so that is initially a good sign for XYZ. It would be good to know how much sales changed. By looking at the income statement, you can see that sales changed by $110,000, from $1,000,000 to $1,110,000. Since we are doing common size analysis, we want to the growth rate in sales stated as a percentage. The formula to calculate growth rate is the following:
Growth Rate = Value at End of Period - Value at Beginning of Period/Value at Beginning of Period X 100.....which in this case is:
Growth Rate = $1,110,000-$1,000,000/$1,000,000 X 100 = 11%....so sales grew by 11% from 2011 to 2012
Analysis of Expenses for XYZ, Inc.
First, the cost of goods sold for the business firm has increased from 2011 to 2012. Cost of goods sold usually includes direct expenses and the cost of purchases for the products made by the company. One reason cost of goods sold has gone up is that sales have gone up but here is an important distinction. The common size income statement shows that the percentage of sales cost of goods sold has gone up. This means that the cost of direct expenses and purchases have gone up. The firm should try to find quality material at a lower cost and lower its direct expenses if possible.
The next point on the common size income statement that we want to analyze is the operating profit or earnings before interest and taxes (EBIT). Operating profit is one of the most important numbers you can analyze because it shows the health of the business firm's core business. All businesses have to sell something, either a service or a product. The income from selling their product or service will show up in operating profit. If it is declining, which it is in the case of XYZ, Inc., that means there is less money for the shareholders and for any other goals that firm management wants to achieve. It is also watched closely by lenders, such as banks, in case the firm needs a loan.
In the case of XYZ, Inc., operating profit has dropped from 17% in 2011 to 7.6$ in 2012. That is a large drop in one year. We can see the reasons for the decrease. First, cost of goods sold dropped. Both selling and administrative expenses and depreciation rose. The firm may have bought some new fixed assets. Sales commissions may have increased due to hiring new sales personnel.
The next point of analysis is the company's non-operating expenses such as interest expense. Interest expense is paid on the company's debt. The income statement does not tell us how much debt the company has, but since depreciation increased, it is reasonable to assume that the firm bought new fixed assets and used debt financing to do it. Interest expense increased as a result. This firm may have purchased new fixed assets at the wrong time since their cost of goods sold was rising.
Next, we look at the firm's net profit. Net profit dropped from 8.4 percent of sales to 2.4 percent of sales. That is a precipitous decline in one year and, if the company has shareholders, will leave them questioning what went wrong. It is a clear signal to management to get a handle on the increasing cost of goods sold and selling and administrative expenses. If there are any fixed assets that can be sold, management should consider selling them to lower both depreciation and interest expense on debt. This should help their common size income statement in 2013.
Common Size Analysis for XYZ, Inc.
|Cost of Goods Sold||500,000||50%||650,000||58.5%|
|Gross Profit Margin||$500,000||50%||$460,000||41.5%|
|Selling & Administrative Expenses||250,000||25%||265,000||23.9%|
|Operating Profit (EBIT)||$170,000||17%||$85,000||7.6%|
|Earnings Before Taxes||$140,000||14%||$45,000||4%|