Common Size Analysis is one of the basics of analysis, which helps the investor or the company or firm itself to analyse their own financial position. This show a firm, that how much it earned by the amount of investment it did in any other business.
Size of the firm is determined by the total assets of the firm or the market capitalization of the firm. In order, to compare a company with another company we have to narrow them down to a common size and only then we can compare the companies; otherwise, we cannot compare them. Because a small firm cannot be compared to a big firm and vice versa.
Common Size Analysis is of two types;
- Vertical Analysis
- Horizontal Analysis
Here we will discuss Vertical Analysis that how it works and what its functions are and what is the method to calculate and how it is calculated. Common Size Analysis is the result in percentages and mostly ‘creditors’ of the company do this analysis of the financial statement in order to know the credibility of the firm.
In Vertical Analysis, each and every item of the Income Statement will be presented in percentage of sales and compared with a standard unit. While on the other hand, each and every item of the Balance Sheet will be presented as percentage of total assets and compared with a standard unit.
Benefits of Vertical Analysis
There are certain benefits of the vertical analysis
- Vertical Analysis helps the creditors to check the credibility of the firm. As creditors are concerned to this analysis mostly.
- It helps investors to decide whether to invest in certain company or no, by viewing the financial statements of the company.
- Brokers also can help the investor to decide whether to invest in a company or not by analysing the financial statements through vertical analysis.
- It provides ease in calculation as well.
- It is not very time consuming.
Drawbacks of Vertical Analysis
There are certain drawbacks of the vertical analysis;
- It is an easy way to analyse the financial statements of the company as it shows what’s happening in the company but it doesn’t show why it is happening.
- All it does is works on the total sales and total assets in an income statement and balance sheet, respectively.
Example for Vertical Analysis
Let’s take an income statement and balance sheet of an anonymous company and calculate its Vertical Analysis.
Income Statement of XYZ Company:
Net sales $2,000,000
Cost of goods sold 100,000
Gross profit 1,900,000
Other expenses 3,000
Net income $1,861,500
Vertical analysis of XYZ Company:
SALES; 2,000,000/ 2,000,000*100 = 100%
CGS; 100,000/2,000,000*100 = 5%
GROSS PROFIT; 1,900,000/2,000,000*100 = 95%
SALARIES; 20,000/2,000,000*100 = 1%
RENT; 6,500/2,000,000*100 = 0.325%
UTILITIES; 8,000/2,000,000*100 = 0.4%
MARKETING; 1,000/2,000,000*100 = 0.05%
OTHER EXPENSES; 3,000/2,000,000*100 = 0.15%
NET INCOME; 1,861,500/2,000,000*100 = 93.075%
The above analysis shows that firm is doing great in terms of its finances. It has controlled its CGS and expenses well and know how to manage them well. It also is earning in great amount and is able to manage its costs well.
The values of Incomes are greater than the values or the amounts of the costs and expenses this shows that the company is good at managing things well and is earning more rather than spending more. This shows that the company is making more profit and its expenses are controlled properly. This can also be taken as the company has got a good management department and they are utilizing the facilities smartly and are not wasting any money over things. So, the investors and creditors will invest in the company without any doubt because of its good management.
The same analysis can be done on balance sheet by taking the total assets instead of sales and then we can compare this analysis with any other company and can come to know the financial position of our company.