Common size financial statement analysis, which is also called a vertical analysis, is just one technique that financial managers use to analyze their financial statements. It is not another type of income statement but is a tool used to analyze the income statement.
What a Common Size Income Statement Analysis Does
Common-size income statement analysis states every line item on the income statement as a percentage of sales. If you have more than one year of financial data, you can compare income statements to see your financial progress. This type of analysis will let you see how revenues and the spending on different types of expenses change from one year to the next.
When you show the items of the income statement as a percentage of the sales figure, it is easy to compare the income and expenses and understand the financial position of the company. Common size analysis is an excellent tool to compare companies of different sizes or to compare different years of data for the same company, as in the example below.
Common size analysis is not as detailed as trend analysis using ratios. It does not provide enough data for some sophisticated investment decisions. For small business managers who have insufficient or no formal education in financial management, the vertical analysis provides a simple way to analyze their financial statements.
Analysis of Revenue for XYZ, Inc.
The two XYZ, Inc. income statements in the table below are for 2017 and 2018. Let's see how XYZ, Inc. did over those years.
First, we see that sales increased from 2017 to 2018, which appears to be a good sign for XYZ. It would be good to know how much the sales figure has changed. By looking at the income statement, you can see that sales changed by $110,000, from $1,000,000 to $1,110,000. Since we are doing a common size analysis, we want the growth rate in sales stated as a percentage. The formula to calculate the growth rate is:
Growth Rate = Value at End of Period - Value at Beginning ÷ Value at Beginning of Period X 100
which, in this case, is:
Growth Rate = $1,110,000-$1,000,000/$1,000,000 X 100 = 11%....so sales grew by 11% from 2017 to 2018
Analysis of Expenses for XYZ, Inc.
First, the cost of goods sold (COGS) for the business firm has increased from 2017 to 2018. The COGS usually includes direct labor costs and the cost of direct materials used in production. One reason the cost of goods sold has gone up is that sales have gone up, but here is an important distinction.
The common size income statement shows that the percentage of COGS has also gone up. This means that the cost of direct expenses and purchases have gone up. This suggests that the firm should try to find quality material at a lower cost and lower its direct expenses if possible.
The next point on the common size income statement that we want to analyze is the operating profit or earnings before interest and taxes (EBIT). Operating profit is one of the most important numbers you can analyze because it shows the health of the business firm's core business.
All businesses have to sell something, either a service or a product. The income from selling the products or services will show up in operating profit. If it is declining, which is in the case of XYZ, Inc., there is less money for the shareholders and for any other goals that the firm's management wants to achieve. It is also watched closely by lenders (e.g., banks) when assessing a company's credit risk.
In the case of XYZ, Inc., operating profit has dropped from 17% in 2017 to 7.6% in 2018. That is a large drop in one year. We can see the reasons for the decrease. The cost of goods sold dropped, while both selling and administrative expenses and depreciation rose. The firm may have bought new fixed assets and/or sales commissions may have increased due to hiring new sales personnel.
The next point of the analysis is the company's non-operating expenses, such as interest expense. Interest expense is paid on the company's debt. The income statement does not tell us how much debt the company has, but since depreciation increased, it is reasonable to assume that the firm bought new fixed assets and used debt financing to do it. Interest expense increased as a result. This firm may have purchased new fixed assets at the wrong time since its COGS was rising during the same period.
Next, we look at the firm's net profit. Net profit dropped from 8.4 percent of sales to 2.4 percent of sales. That is a precipitous decline in one year and, if the company has shareholders, it will leave them questioning what went wrong. It is a clear signal to management that it needs to get a handle on the increasing COGS, as well as the increased sales costs and administrative expenses. If there are any fixed assets that can be sold, management should consider selling them to lower both the depreciation and interest expense on debt. This should help the company's common size income statement in 2019.
Common Size Analysis for XYZ, Inc.
|Cost of Goods Sold||500,000||50%||650,000||58.5%|
|Gross Profit Margin||$500,000||50%||$460,000||41.5%|
|Selling & Administrative Expenses||250,000||25%||265,000||23.9%|
|Operating Profit (EBIT)||$170,000||17%||$85,000||7.6%|
|Earnings Before Taxes||$140,000||14%||$45,000||4%|