Financial Ratio Analysis



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?





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