Question

2.) What is vertical analysis, and what is its purpose? What is the purpose of common-size statements?

Answer 1

Answer:

Vertical Analysis

Vertical analysis, also called common-size analysis, is a financial analysis tool that lists each line item on the financial statements as a percentage of its total category. In other words, it’s a method used to analyze financial statements by comparing individual entries as a proportion of their total accounts like assets, liabilities, and equity. The balance sheet uses this presentation on individual items like cash or a group of items like current assets. Cash is listed as an individual entry in the asset section with the total balance being listed on the left and its percentage of total assets being listed on the right. The income statement also uses this presentation with revenue entries referencing total revenues and expense entries referencing total expenses.

Purpose of Vertical Analysis

The most common use of vertical analysis is within a financial statement for a single time period, so that one can see the relative proportions of account balances. Vertical analysis is also useful for timeline analysis, to see relative changes in accounts over time, such as on a comparative basis over a five year period.

The most common use of vertical analysis in income statement is to show the various expenses line items as percentage of sales, though it can also be used to show the percentage of different revenue line items that make up total sales.

Purpose of Common Size Statements

The main purpose of preparing common size statements are as follows:

1.  Presenting the change in various items in relation to total assets or total liabilities or net sales: One of the major drawback of comparative financial statements is that they do not present the change in various items in relation to total assets or total liabilities or net sales. This drawback is removed through the preparation of Common size statements.

2.  Establishing a relationship: Over a period of time, a relationship has been established between various items of the Profit and Loss Account i.e. Income Statement to sales and various items of Balance Sheet to total assets or total liabilities. Meaningful conclusions can be drawn by studying the changes in relationship.

3. Providing a common base for comparison: Common size statements provide a common base for comparison. Financial Statements of different periods and different firms can be converted into uniform common size format irrespective of the size of individual items. Thus, the Common size statements facilitate the comparison of profitability and financial position of two or more business over a period of time.