# Vertical Analysis (Common Size Analysis) - Explained

What is Vertical Analysis?

# What is Vertical Analysis?

Common-size analysis, also known as vertical analysis, converts each line of financial statement data to an easily comparable, or common-size, amount measured as a percent. The result is the creating of a Common-Size Financial Statement

This is done by stating income statement items as a percent of net sales and balance sheet items as a percent of total assets (or total liabilities and shareholders’ equity).

## How is a formal common-size analysis prepared?

Net sales are used as the base for the income statement, and total assets (or total liabilities and shareholders’ equity) are used as the base for the balance sheet.

That is, for the income statement, each item is measured as a percent of net sales, and for the balance sheet, each item is measured as a percent of total assets (or total liabilities and shareholders’ equity).

In general, managers prefer expenses as a percent of net sales to decrease over time, and profit figures as a percent of net sales to increase over time.

## How is Common-Size Analysis Used?

There are two reasons to use common-size analysis: (1) to evaluate information from one period to the next within a company and (2) to evaluate a company relative to its competitors.

Common- size analysis answers such questions as “how do our current assets as a percent of total assets compare with last year?” and “how does our net income as a percent of net sales compare with that of our competitors?”

## Using Common-Size Analysis to Evaluate Competitors

Common-size analysis is also an effective way of comparing two companies with different levels of revenues and assets.

If both companies have similar levels of net sales and total assets, it is reasonable to assume that the more profitable company is the better performer.

However, most companies are not the same size. How do we compare companies of different sizes?

Common-size analysis enables us to compare companies on equal ground,

Common-size analysis is obviously crucial to comparative analysis. In fact, some sources of industry data present the information exclusively in a common-size format, and most of the accounting software available today has been engineered to facilitate this type of analysis.

## Example of Vertical Analysis

If a company has a gross sale amounting to \$5 million in which \$1 million represents the cost of goods sold, \$2 million used for general expenses and a tax rate of 25%.

Below is how the income statement of that company will look like using vertical analysis method;

Gross sales= 100%

Cost of Goods Sold = 20% giving us a gross profit of 80%.

That is, (\$5 million (100%) - (\$1 million (20%) = \$4 million (80%).

Further in the calculation; General and administrative expenses is \$2 million (40%).

Operating income is \$2 million (40%) Tax rate of 25% = 500,000 (10%) Hence, the Net income is \$1.5 million (30%)

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