ISL459U-FINANCIAL STATEMENT ANALYSIS
Chapter 3: Vertical Analysis: Common Size Financial Statements
The Analysis Of Financial Statements
The financial statements consist of several items and numbers; they should be evaluated by comparing the related items. In this framework, it is required to analyze the financial statements by stating each item in terms of a basic determinant item as realized in the vertical analysis which is also named as common share analysis. It is realized for one period financial statement, not comparatively with more than one period, so the vertical analysis is a static type of analysis. However, it can be realized for more than one period and the comparisons of these distributions can be used as a dynamic analysis.
In vertical analysis, each item in the financial statements is stated as a percentage of another item or the total amount. In the vertical analysis of a balance sheet the total amount of assets (or liabilities plus shareholders’ equity) is taken as 100, the proportion of each item to total assets is calculated. Additionally, the proportion of each item to its related subgroup may also be calculated.
There exist two main advantages of vertical analysis against others analysis techniques:
• The proportion of each balance sheet item can be calculated to total balance sheet amount and/or to the total of its subgroup. • It may not be possible to make meaningful comparisons of the numeric values and/or changes in the financial statements of the companies operating in the same sector. By stating the items in the balance sheet as a proportion to total balance sheet amount, it becomes possible to make such comparisons.
Vertical analysis allows analyzing the distribution of the asset and liability items as a percentage of total balance sheet amount and items in the income statements as a proportion to Net Sales. This is very important to address the asset and liability composition of the company. However, this does not contribute to the decision making process in relation with the strength of the What are the principles of the vertical financial asset liability composition of the company.
Common Size Financial Statements
In vertical analysis each item in the financial statements is stated as a percentage of another item or the total amount. The proportion of financial statement items to a particular item or total amount provides an opportunity for analysis to compare with previous years and other businesses in the industry.
Common Size Balance Sheet
In vertical analysis, taking the total balance sheet amount as 100, the proportion of each asset or liability item is calculated. Additionally, by taking the total amount of subgroups as 100, the proportion of each item to the total sub group amount can be calculated.
The followings are the relevant formulas:
Proportion of Total Balance Sheet Amount= Amount of Item×100/Total Amount of Asset
Proportion of Total Subgroup Amount = Amount of Item × 100 / Total Amount of Subgroup
In order to realize the vertical analysis of the balance sheet, the items and the total amounts should be available. The net amounts of the items should be used when calculating the proportions. The analysis is realized in three columns; in the first column the amount of items is stated, in the second column the proportion of each item to the total of subgroup is stated and in the third column the proportion of each item to the total of balance sheet are stated.
Common Size Income Statement
In the income statement, the Net Sales Revenue amount is taken as 100 and other items are stated as a proportion to the sales amount by using the following formula:
Proportion of Each Item = Amount of Item × 100 /Net Sales
By using this formula for all of the income statement items, a new proportional income statement is generated.
In vertical analysis, taking the total balance sheet amount as 100, the proportion of each asset or liability item is calculated. Also, by taking the total amount of subgroups as 100, the proportion of each item to total sub group amount can be calculated. Also for income statement, the Net Sales Revenue amount is taken as 100 and other items are stated as a proportion to the sales amount.
The Interpretatıon Basis of the Vertical Analysis
The compositions of the balance sheet and the income statement as determined by the vertical analysis show different aspects of the financial structure of a company. While the proportions of the balance sheet items indicate the share of the item in total balance sheet amount and/or subgroup, the proportions of the income statement indicate the share of the item in total sales. In this framework, after restating the balance sheet and the income statement by the vertical analysis, the proportions of each item should be evaluated whether they are appropriate in comparison with some criteria such as sector standards.
The vertical analysis reveals the financial structure of a company as well as how the net income is generated. In this framework, the vertical analysis is generally realized for individual year. By using the composition of the balance sheet and the income statement for more than one year, it is also possible to analyze the developments in the structures. The comparison of the composition of the balance sheet and income statement by the other companies operating in the same sector may also give some indications.
The Interpretation of the Common Size Balance Sheet
The interpretation of the balance sheet produced by the vertical analysis is realized in two steps:
The evaluation of each items
The main purpose of this analysis is to evaluate whether the proportion of the items in total balance sheet amount and also that of in the subgroup amount is proper by taking into account the characteristics of the item. Firstly, the proportion of the item in total balance sheet amount and also that of in the subgroup amount is calculated. It is determined whether this proportion is appropriate by taking into account the characteristics of the item and the type of the company. The evaluation should be realized individually and also together with the other related items. By that way, it can be concluded that the amount of item is proper or not. If the proportion of the asset item, together with the other relevant item(s), is adequate to cover the payment obligations, it is accepted as adequate. If the proportion of the liability item has the capacity to be paid, it is accepted as adequate. If the proportion of the equity item is having the capacity to be paid, it is accepted as adequate. If the item is an income statement item, it is accepted as adequate if it is more than the total of the succeeding items. Similarly, an expense item is acceptable, if it is less than the total of the succeeding profit or income items.
The evaluations hereby summarized are used to foresee the future financial and operational directions of the company.
The evaluation of the asset and liability composition
In the process of the evaluation of asset and liability composition, the proportion of the subgroups of the total balance sheet amount is compared with that of the companies operating in the same sector. The evaluation of asset and liability composition is realized in three steps: The evaluation of asset composition,The evaluation of liability composition ,The evaluation of asset-liability relation. The industry of the company and also the price movements affect the asset composition of a company. In trade business, it is naturally expected that the current assets dominate in the balance sheet as such kinds of companies operate on a buy and sell basis. In the industrial sectors, as the production process necessitates investment to fixed assets such as machinery and equipment, the noncurrent assets generally dominate the balance sheet.
While evaluating the asset composition of a company, the proportions of the current and non-current asset to total asset are evaluated.
In order to evaluate the liability and equity composition of the company, the short and the long term liabilities and the equity proportions should be calculated. In all companies operating either trade business or industrial production, the proportion of the equity to total sources should be higher enough to indicate the financial strength of the company. It is generally accepted that at least half of the
total sources should be constituted by the equity and the remaining part by the short or long term liabilities. However, in countries like Turkey as the capital markets are not mature and the companies are basically in the form of small and medium enterprises, the operations and investments are mainly financed by external sources. The main types of external financial sources are bank loans and suppliers’ credits.
By evaluating the asset-source relation of a company, it is possible to determine the funding sources of the current and non-current assets. The current assets which are used for the operations of the company should be financed by the long term liabilities in order to create net working capital for the company. The non-current assets principally should be financed by long term liabilities and/or equity. By that way, the company may cover short term payables with short term liabilities and may continue to its operations that generate sales and profit. When the current assets are less than the current liabilities, this will create deficiency in the net working capital. Consequently, the company may face financing problems to meet its obligations on time.
However, in some cases the existence of net working capital may not be adequate. The current assets should constitute the required items in order to meet the short term liabilities, the orders of the customers and continue the production. The quality of the current assets also should be elaborated. Furthermore, the related asset and liability items such as trade payables and inventory should also be examined.
The Interpretation of the Common Size Income Statement
In order to realize the vertical analysis of the income statement, firstly all items should be stated as a proportion of net sales. By that way each item should be evaluated in terms of its contribution to profit. The revenue and profit related items are accepted as adequate if they cover the succeeding expenses or losses. The profit items are better if they constitute a higher proportion of the net sales. In order to elaborate the profit items, it should also be taken into account whether the profit item is generated from the main operations of the company and whether it allows self-financing. Generally, it is desired not to have any extraordinary expenses and losses.