How to Interpret Financial Statements By Using a Vertical Analysis

Written by bryan keythman
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How to Interpret Financial Statements By Using a Vertical Analysis
Vertical analysis expresses an income statement's items as percentages of net sales. (Jupiterimages/Photos.com/Getty Images)

You can use vertical analysis on financial statements to analyse 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 per cent of net sales on a common-size income statement. This helps you spot potential problems better than analysing only dollar amounts.

Skill level:
Moderate

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Things you need

  • Income statement
  • Balance sheet

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Instructions

    Income Statement

  1. 1

    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 £6,500 in net sales by £6,500 in net sales and £5,573 in cost of goods sold by £6,500 in net sales, which equals 1 and 0.8575, respectively.

  2. 2

    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 per cent and 0.8575 to 85.8 per cent.

  3. 3

    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 per cent in a column to the right of £6,500 in net sales and 85.8 per cent to the right of £5,573 in cost of goods sold.

    Balance Sheet

  1. 1

    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 £1,651 in cash by £13,000 in total assets and £13,000 in total assets by £13,000 in total assets, which equals 0.127 and 1, respectively.

  2. 2

    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 per cent and 1 to 100.0 per cent.

  3. 3

    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 per cent in a column to the right of £1,651 in cash and 100.0 per cent to the right of £13,000 in total assets.

  4. 4

    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 per cent of net sales to 35 per cent of net sales from one year to the next, and the industry average is 25 per cent, this could signal a problem with managing expenses.

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