VERTICAL ANALYSIS

One of the most frequently used approaches in probing a balance sheet and an income statement is to list the individual items between two successive years by reducing the numbers on the financial statements to comparable percentages. This is called "vertical analysis" or "common-size statement analysis."

As shown in the table below, each component of Eastman's balance sheet related to assets is expressed as a percentage of total assets, and each component related to liabilities and owners' equity is expressed as a percentage of total liabilities and shareholders' equity. Vertical analysis is interesting to use for comparing the performance of one business to another, or one division to another, because it ignores the difference in the size of the individual accounts. All elements are converted on comparable terms-that is, a percentage.

Vertical analysis also reveals the change in mix between several elements of a balance sheet and between two consecutive balance sheers. For example, the table shows that, in 2004, current assets represented 36.16 cents out of every asset dollar of the company. In 2005, this ratio was reduced to 33.33 cents. This is evidenced by the fact that prepaid expenses dropped from 3.69 cents to 3.33 cents. In addition, it shows that accounts receivable and inventory, which represent a greater percentage of the total assets, were also reduced. The same analysis can be performed for each component in the liability and shareholders' equity accounts.

VERTICAL ANALYSIS OF THE BALANCE SHEET

Eastman Technologies Inc.
Balance Sheets as at December 31

Assets	2005	%	2004	%
Current Assets

Cash	$ 22,000	1.22	18,000	1.21
Prepaid expenses	60,000	3.33	55,000	3.69
Accounts receivable	300,000	16.67	280,000	18.82
Inventory	218,000	12.11	185,000	12.44

Total current assets	600,000	33.33	538,000	36.16

Capital assets (at cost)	1,340,000	74.44	1,050,000	70.56
Accumulated depreciation	140.000	7.77	100,000	6.72
Capital assets (net)	1,200,000	66.67	950,000	63.84

Total Assets	$ 1,800,000	100.00	$ 1,488,000	100.00

Liabilities

Current liabilities

Accounts payable	$ 195,000	10.83	175,000	11.76
Notes payable	150,000	8.33	135,000	9.07
Accrued expenses	20,000	1.11	18,000	1.21
Taxes payable	80.000	4.45	70.000	4.71
Total current liabilities	445,000	24.72	398,000	26.75

Long-term debts	800,000	44.44	600,000	40.32

Common shares	300,000	16.67	285,000	19.15
Retained earnings	255,000	14.17	205,000	13.78

Shareholders' equity	555,000	30.84	490,000	32.93

Total liabilities and equity	$ 1,800,000	100.00	$ 1,488,000	100.00

Vertical analysis of the income statement provides the same type of information. As shown in the table below, each component of Eastman's income statement is converted to a percentage of total sales. Eastman's income performance improved over the accounting period; in 2005, for every dollar sale, it made 3.9 cents compared to 3.3 cents in 2004. Although the overall profitability performance of the company improved, it is evident that some accounts improved and others deteriorated. For example, the cost of goods sold went from 77.5% to 76.0%, which improved the company's margin from 22.5% to 24.0%. Salary and rent accounts improved, while depreciation showed an increase.

VERTICAL ANALYSIS OF THE INCOME STATEMENT

Eastman Technologies Inc.
Income Statements for the Years ended December 31

	2005	% of sales	2004	% of sales
Net sales	$ 2,500,000	100.0	$ 2,250,000	100.0
Cost of goods sold	1,900,000	76.0	1,743,000	77.5

Gross margin	600,000	24.0	507,000	22.5

Operating expenses

Selling expenses:
Sales salaries	$ 140,000	5.6	128,000	5.7
Advertising expenses	20,000	0.8	19,000	0.9
Total selling expenses	160,000	6.4	147,000	6.6

Administrative expenses:
Office salaries	170,000	6.8	155,000	6.9
Rent	20,000	0.8	20,000	0.9
Depreciation	40,000	1.6	30,000	1.3
Total administration expenses	230,000	9.2	205,000	9.1

Total operating expenses	390,000	15.6	352,000	15.6

Operating income	210,000	8.4	155,000	6.8

Other income	20,000	0.8	18,000	0.8
Other expenses (interest)	35,000	1.4	23,000	1.0
	15,000	0.6	5,000	0.2
Income before taxes	195,000	7.8	150,000	6.6

Income taxes	97,500	3.9	75,000	3.3

Income after taxes	$ 97,500	3.9	$ 75,000	3.3

Vertical analysis not only enables management to compare financial statements from one year to the next, between companies or operating divisions, but it can also reveal sufficient information for management to answer the following questions:

• Is our company's capital structure in line with that of the industry?
• Is the ratio of the company's current assets to total assets favourable?
• Is the investment in fixed assets in the right proportion?
• Are the manufacturing costs too high?
• Are the operating expenses too high?
• Is the ratio of profit to sales adequate?

Financial ratio analysis