Vertical Analysis: Videos & Practice Problems

Understanding financial statements is crucial for effective financial analysis, and one key method for analyzing these statements is through vertical analysis. Unlike horizontal analysis, which examines percentage changes over time, vertical analysis focuses on expressing each line item as a percentage of a base amount within the same financial statement. This technique can be applied to both the income statement and the balance sheet.

For the income statement, the base amount is typically the net sales, which represents the total revenue generated from sales after deducting returns and allowances. In contrast, for the balance sheet, the base amount is total assets, while total liabilities and equity can also serve as the base since they are equal to total assets.

To perform vertical analysis, the line item amount is divided by the base amount, and the result is then multiplied by 100 to convert it into a percentage. For example, if the cost of goods sold is $54,912 and net sales are $65,455, the calculation would be:

Cost of Goods Sold Percentage = \(\frac{54,912}{65,455} \times 100 = 83.9\%\)

This percentage indicates that approximately 84% of net sales are used to cover the cost of goods sold. Similarly, gross profit can be calculated as a percentage of net sales, providing insight into profitability. For instance, if gross profit is $10,543, the calculation would be:

Gross Profit Percentage = \(\frac{10,543}{65,455} \times 100 = 16.1\%\)

Continuing with this method, operating expenses can also be analyzed. For example, if selling expenses amount to $2,411, the calculation would be:

Selling Expense Percentage = \(\frac{2,411}{65,455} \times 100 = 3.7\%\)

This analysis reveals how much of each dollar in sales is allocated to various expenses, ultimately leading to net income. For instance, if net income is $3,120, the calculation would be:

Net Income Percentage = \(\frac{3,120}{65,455} \times 100 = 4.8\%\)

Through vertical analysis, stakeholders can gain valuable insights into the financial health of a business, understanding how revenues are distributed across expenses and profits. This method not only aids in internal decision-making but also enhances the ability to communicate financial performance to external parties.

In conducting a vertical analysis of the income statement for the year 2017, the base used for calculations is net sales, which amounts to $58,081. This analysis allows for a clear understanding of each line item as a percentage of net sales, facilitating comparisons both within the year and across different years.

Starting with net sales, it is always represented as 100% of itself. The cost of goods sold (COGS) for 2017 is $45,377, which when divided by net sales gives a COGS percentage of 78.1%. This indicates that a significant portion of sales revenue is allocated to cover the cost of goods sold. The gross profit, calculated as net sales minus COGS, is $12,704, resulting in a gross profit percentage of 21.9%. This percentage reflects the remaining revenue after accounting for COGS, and it is essential to note that this is a decrease from the 2018 gross profit percentage of 16.1%, which could signal a trend that is important for stakeholders to monitor.

Continuing down the income statement, rent expense remains constant at $2,411, but due to the lower net sales, it represents a larger percentage of total sales at 4.2%. Other expenses, such as depreciation, total $902, which corresponds to 1.6% of net sales. Total operating expenses amount to $4,184, equating to 7.2% of net sales. Interest expense is recorded at $400, or 0.7%, while other expenses total $120, representing 0.2% of net sales.

Income before taxes is calculated at $8,000, which is 13.8% of net sales. The income tax expense of $3,200 results in a tax percentage of 5.5%. Finally, the net income for 2017 is $4,810, which translates to 8.3% of net sales. This figure is particularly significant as it indicates that for every dollar of sales, the company retains 8.3 cents after all expenses, a decrease from the 4.8 cents retained in 2018. Such a decline in net income percentage could raise concerns regarding expense management and profitability, prompting further analysis by investors and management alike.

Overall, vertical analysis provides a straightforward method for evaluating financial performance, allowing for insightful comparisons and highlighting areas that may require attention in future financial planning.