4 1. OBJECTIVE Use vertical analysis techniques to analyze a comparative income statement and balance sheet. Let’s learn the techniques of vertical analysis of financial statements using comparative financial statements. Comparative statementsFinancial statements presented side by side for two or more years are financial statements presented side by side for two or more years. Figure 23.1 shows the comparative income statement of California Products, Inc., for the years 2007 and 2008. FIGURE 23.1 Comparative Income Statement—Vertical Analysis
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VERTICAL ANALYSIS OF THE INCOME STATEMENTVertical analysis of the income statement expresses each item as a percentage of the net sales figure. In each column the net sales figure is used as the base, or 100 percent. Every amount in the column is expressed as a percentage of net sales. To compute an item’s percentage of net sales, divide the amount of that item by the amount of net sales. For example, in 2008 the cost of goods sold is 59.1 percent of net sales.  <![CDATA[<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=gif::::/sites/dl/free/0073029920/0073029920_023_001.gif','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>]]>
In making these types of computations, it is customary to carry the division one place further than needed and then round off. The usual practice is to round percentages to the nearest one-tenth of a percent. The computation in the example is made to the fourth decimal (0.5908). That decimal fraction is converted to a percentage by moving the decimal point two places to the right (59.08 percent). The percentage is then rounded to the nearest one-tenth of a percent; hence, 59.08 is rounded to 59.1. | COMPUTERS IN ACCOUNTING | << | SPREADSHEETS: MORE THAN NUMBERS Success in accounting is more than crunching numbers. Accountants use technology to analyze and interpret financial data, and to contribute to key management decisions. Spreadsheet applications such as Lotus 1-2-3 and Microsoft Excel are among the most powerful and widely used tools in business. Budgets, financial statements, business plans, fixed assets reports, and inventory control records are just a few uses of the electronic spreadsheet. Spreadsheets are reference tables that arrange data in rows and columns and provide formulas for quick computations. The user can connect multiple spreadsheets, creating dependencies between reports and analyzing the relationships between financial scenarios. Voice-enabled tools help users enter and proof numbers without the keyboard. Using macros (simple programs that list a sequence of actions), the user can automate data entry tasks and routine calculations. The business community also uses spreadsheet technologies in the following ways. Communicate and Collaborate - Convert numbers into customized visual presentations.
- E-mail electronic spreadsheets to co-workers without leaving the spreadsheet application.
- Utilize edit tracking features to work collaboratively with co-workers on a single spreadsheet.
Analyze and Interpret - Investigate the effects of changing key variables or assumptions in the spreadsheet.
- Forecast financial outcomes.
Exchange Data between Software Applications - Move files between spreadsheets and accounting software modules.
- Export data to create data warehouses of financial information.
THINKING CRITICALLY
Describe how you might use an electronic spreadsheet for vertical or horizontal analysis of financial statements. What formulas would you use? INTERNET APPLICATION
Locate the Web site for a commercial spreadsheet software application. Find the “Fact Sheet” or “Features List” for the current release. Prepare a report containing the application name and release date. List five new enhancements or features contained in the product. Describe potential uses for these enhancements as they relate to the preparation and presentation of financial information. |
In Figure 23.1 note that gross sales are more than 100 percent ($3,105,650 % $2,970,200 = 104.6 percent in 2008). That is because of Sales Returns and Allowances, which are 4.6 percent of net sales. | ABOUT ACCOUNTING | | NYSE | | The New York Stock Exchange (NYSE) lists more than 3,000 companies from all over the world whose collective worth is $15 trillion in global market capitalization. |
The percentages are added and subtracted, giving informative subtotals and totals. Because of rounding, the individual percentages may not add up to 100 percent. In this case one or more percentages is adjusted slightly until the total equals 100 percent. If the difference is more than a small amount, it is probable that an error has been made, and all the computations should be checked before adjusting any of the amounts. Financial statements with items expressed as percentages of a base amount are called common-size statementFinancial statements with items expressed as percentages of a base amount The last two columns in the comparative income statement are referred to as a comparative common-size statement. Percentages obtained by vertical analysis of the income statement are useful when compared with the company’s percentages for prior years. It is helpful to make comparisons with several years to detect trends, but even year-to-year comparisons are useful. For example, the comparative income statement of California Products, Inc., shows gross profit on sales of 42.2 percent in 2007 but only 40.9 percent in 2008. A comparison with the industry average might be helpful. For example, suppose that trade association publications reveal that the average gross profit for the industry is 51.7 percent. California Products, Inc.’s gross profit on sales compares unfavorably to the industry average. This could be attributed to peculiarities of its operations, local competition, or other factors. However, it indicates the need for further examination. important!
Rounding
In statement analysis, it is customary to compute percentages to the nearest one-tenth of a percent. This procedure is followed in this chapter. VERTICAL ANALYSIS OF THE BALANCE SHEETVertical analysis of the balance sheet expresses each item as either a percentage of total assets or of total liabilities and stockholders’ equity. important!
Percentages
In common-size statements, percentages (of net sales on the income statement and of assets on the balance sheet) are shown instead of dollar amounts. Figure 23.2 shows a comparative balance sheet for California Products, Inc., with the vertical analysis results. The pair of columns on the right shows each item as a percentage of total assets for each year. The more recent year is on the left. On December 31, 2008, the cash balance was $108,886 and the total assets were $553,016. Thus the cash balance is 19.7 percent of total assets in 2008. FIGURE 23.2 Comparative Balance Sheet—Vertical Analysis
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In rounding off it might be necessary to adjust one or more of the figures to obtain an even 100 percent for each total. Vertical analysis percentages of the balance sheet are very useful when they are compared with the percentages of the same company for previous years and with those of other companies in the same industry. Changes in the percentages might reveal situations that need investigation. For example, the comparative balance sheet of California Products, Inc., shows that cash has increased from 16.3 percent of total assets in 2007 to 19.7 percent of total assets in 2008. The accountant may suggest that this increase be studied. | Section 1: Self Review | | QUESTIONS | | 1. | What is a common-size statement? | | 2. | How does the computation phase of statement analysis differ from the interpretation phase? | | 3. | What item serves as the base for the percentage calculations in a vertical analysis of the income statement? | | EXERCISES | | 4. | Which of the following is true of vertical analysis?
- Each item on the balance sheet is expressed as a percentage of total liabilities.
- Each item in the income statement is divided by net sales.
- Each item in the income statement is expressed as a percentage of net income.
- The amount of increase or decrease for each item in the income statement is divided by net sales.
| | 5. | In a vertical analysis of a balance sheet, each item is expressed as a percentage of
- total assets or total liabilities.
- total assets or total stockholders’ equity.
- total assets or total liabilities and stockholders’ equity.
- total liabilities or total stockholders’ equity.
| | ANALYSIS | | 6. | The gross profit on sales for 2007 and 2008 are $464,000 and $429,000, respectively. Net sales for 2007 and 2008 are $1,225,000 and $1,050,000. Net income after income taxes for 2007 and 2008 are $64,000 and $29,000. What conclusions can you draw from these figures? |
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Exercise 23.1, 23.2, 23.6 Problem 23.1A, 23.2A, 23.1B, 23.2B |
