How to Interpret Financial Statements By Using a Vertical Analysis

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You can use vertical analysis on financial statements to analyze the relative size of each line item. A financial statement that shows vertical analysis is called a common-size financial statement and expresses the dollar amount of each line item as a percentage of a base amount on the financial statement, such as net sales on the income statement and total assets on the balance sheet. For example, selling expenses may be shown as 20 percent of net sales on a common-size income statement. This helps you spot potential problems better than analyzing only dollar amounts.

Things You'll Need

  • Income statement
  • Balance sheet

Income Statement

  • Divide the dollar figure of each line item on the income statement by the dollar figure of net sales, which is the base amount with which all other amounts will be compared as a percentage. For example, divide $10,000 in net sales by $10,000 in net sales and $8,575 in cost of goods sold by $10,000 in net sales, which equals 1 and 0.8575, respectively.

  • Convert each result to a percentage by moving the decimal two places to the right, and round each percentage to one digit to the right of the decimal. In the example, convert 1 to 100.0 percent and 0.8575 to 85.8 percent.

  • Write each percentage result next to the corresponding dollar figure of each line item in a new column to the right of the existing column of dollar amounts. This results in a common-size income statement with each line item written as a percentage of net sales in a separate column. For example, write 100.0 percent in a column to the right of $10,000 in net sales and 85.8 percent to the right of $8,575 in cost of goods sold.

Balance Sheet

  • Divide the dollar figure of each line item on the balance sheet by the dollar figure of total assets, which is the base amount with which all other amounts will be compared as a percentage. For example, divide $2,540 in cash by $20,000 in total assets and $20,000 in total assets by $20,000 in total assets, which equals 0.127 and 1, respectively.

  • Convert each result to a percentage by moving the decimal two places to the right, and round each percentage to one digit to the right of the decimal. In the example, convert 0.127 to 12.7 percent and 1 to 100.0 percent.

  • Write each percentage result next to the corresponding dollar figure of each line item in a new column to the right of the existing column of dollar amounts. This results in a common-size balance sheet with each line item written as a percentage of total assets in a separate column. For example, write 12.7 percent in a column to the right of $2,540 in cash and 100.0 percent to the right of $20,000 in total assets.

  • Compare the percentages of each common-size financial statement with those of previous accounting periods and with industry averages, which can be found on many financial websites that provide stock information, to identify any abnormal trends or changes that may require more attention. For example, if selling expenses rise from 20 percent of net sales to 35 percent of net sales from one year to the next, and the industry average is 25 percent, this could signal a problem with managing expenses.

References

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