How to Do a Vertical Test for Accounting
Financial statements display all revenue and expenses related to a certain period in one column. Vertical analysis involves comparing figures within that column, as opposed to horizontal analysis, which involves equating current financial results to a historical base year (See Reference 2). Accountants perform a vertical test by equating a number on the financial statement with another key figure from the same period, such as revenue or total assets, for the purpose of comparison to other businesses or prior results (See Reference 1).
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Things You'll Need
- financial statements
- comparison statements
- internet access
- computer
- spreadsheet program
Instructions
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1
Complete the month-end closing process, including all journal entries, adjustments, and reports. Create, at minimum, the income statement and balance sheet summary reports for the current period. Make note of any anomalies or procedural changes.
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2
Add columns for common size percentages or convert to common size financial statements. Common size percentages display each item on the financial statement as a percentage of another key figure, such as revenue on the income statement or total assets on the balance sheet summary. These percentages can either be displayed as a separate column beside the hard numbers or they can completely replace the hard figures (See Reference 3).
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3
Gather the financial statements to which you'd like to compare your firm's results. Businesses often compare financial results to their results from prior periods, the results of competitors and industry averages. Public companies are required to report their financial results to the Securities and Exchange Commission, which makes them available on line at the Electronic Data Gathering, Analysis and Retrieval (commonly known as EDGAR) website. EDGAR makes it easy for businesses to obtain competitor financial statements for comparison.
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4
Compare the item that you are concerned with by looking at its percentage of total revenue or assets, not the dollar amount. Because the items on the financial statements have been converted to percentages, large differences or fluctuations in dollar amounts will not impact your analysis. For example, if the industry average for food cost is 30 percent, then both small restaurants and large chain restaurants should be operating at close to 30 percent, regardless of the vast differences in dollar figures (See Reference 4).
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Identify and research material variances between percentages on the two sets of financial statements. Variances can occur for a host of reasons, including, but not limited to, differences in accounting practices, differences in operational procedures, incorrect inventory counts, theft and unplanned business interruption.
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Tips & Warnings
The income statement is generally used to compare expenses as a percentage of revenue, while the balance sheet is usually used to diagnose liquidity issues.
Be sure to read the disclosures on your competitor's financial statements. They often explain anomalies such as changes in accounting processes or reasons for business interruption.
Small businesses often make comparisons with similar local competitors. However, the more robust your list of comparisons, the closer you can come to calculating an accurate industry-wide average.
References
- Photo Credit financial charts image by Chad McDermott from Fotolia.com
