Each vertical common-size comparison uses a single financial statement from a single year. In other words, you might do a vertical comparison of a corporation’s 2011 income statement, and then another one for its 2012 income statement. These comparisons are intended to measure the allocation and usage of value within the organization by measuring the proportion of total value that is being distributed in each entry of the financial statement.
They’re called vertical comparisons because the items you’re comparing on an income statement appear in a vertical list, rather than next to each other.
The following example takes you on a quick walk through a vertical common-size comparison of an income statement to show you how this process basically works.
You start at the very top with net sales (recall that this can also be called sales, revenue from sales, gross revenue, and so forth). That’s the point you’re referencing because that’s the total amount of money that the corporation brought in during the period being examined.
From here, you can break down any other part of the income statement as a percentage of net sales. So if your net sales are $100,000 and your cost of goods sold (COGS) are $65,000, then according to your vertical comparison, COGS represent 65 percent of net sales. That means that 65 percent of all net sales are going into the cost of production, leaving 35 percent to pay for other expenses.
So, say that earnings before income and tax (EBIT) is 5 percent. That means that administrative costs took up 30 percent of the net sales, leaving only 5 percent to be taxed on. By the end, the net income is 1 percent. The following table puts this data in order so you can see what this scenario looks like.
| Income Statement | Nom. Value | Percentage of Net |
|---|---|---|
| Net sales: | $100,000 | 100% |
| COGS: | $65,000 | 65% |
| Gross margin: | $35,000 | 35% |
| Admin costs: | $30,000 | 30% |
| EBIT: | $5,000 | 5% |
| Interest & tax: | $4,000 | 4% |
| Net income: | $1,000 | 1% |
By doing this analysis, you can easily compare items in the income statement as a proportion of total income. Of course, this can also be done in a balance sheet as a percentage of total assets, or in the statement of cash flows by breaking down each type of activity (for example, cash flow from operating activities) as a percentage of the total cash flows.
This analysis makes it very simple to determine how a corporation’s value is being utilized and whether each item on the financial statements is efficiently being managed.
The ability to perform such an analysis becomes particularly useful when you begin talking about horizontal comparisons, industry comparisons, and time comparisons. You can compare your vertical analyses to other corporations in the same industry to see how the value utilization of your corporation is being managed compared to others in the same industry.
Vertical analyses can also be tracked over time to see whether individual items are improving over a period of several years, allowing you to track trends.