Common-size income statements are expressed in percentages instead of amounts. Reducing each constituent of income statement to simple percentages expressed in relation to specific base, make the comparative analysis easy as significance of amounts is not going to confuse us.
Common-size income statements can be prepared in two ways:
- Vertical analysis: Under vertical common-size analysis, each item of income statement is expressed as a percentage of total revenue for the period. In simple words each item is expressed as a proportion of total revenue. This analysis is conducted to analyze how much a certain item has consumed from or contributed to total revenue. In other words it helps understand the fluctuation in the net profit.
- Horizontal analysis: Under this analysis, each item is expressed a percentage of similar corresponding item from base period. This analysis help us determine the change in each item over a period of time. Basically each item is compared to corresponding similar item in previous period, next period or a budget. In other words, this analysis help us determine if item has progressed or regressed compared to estimates or specific period figures.
1 Vertical common-size income statement
Preparing vertical common-size income statements is pretty straight-forward. Consider the following example income statement:
| PakAccountants Inc. | |
| Income Statement as at _________ | |
| Sales | 850,000 |
| Cost of Sales | (730,000) |
| Gross profit | 120,000 |
| Administrative expenses | (35,000) |
| Distribution expenses | (12,000) |
| Operating profit | 73,000 |
| Interest expense | (11,000) |
| Profit before tax | 62,000 |
| Tax | (9,000) |
| Profit after tax | 53,000 |
Take each item and divide it over sales amount and multiply it to 100 to get the percentage. For example, dividing cost of sales over sales will give us 0.8588 [730,000 / 850,000]. Multiplying 0.8588 with 100 gives us 85.88%.
Remember the figures mentioned in brackets mean they are subtracted. This adds to the understanding of user as they can clearly see what figures are being deducted. Personally I like to keep the brackets with percentages as well so that users can understand these figures pertain to expenses or anything causing the profits/revenue to reduce.
Following shows the income statement with workings and percentages calculated:
| PakAccountants Inc. | |||
| Income Statement as at _________ | |||
| $ | Working | % | |
| Sales | 850,000 | 850,000/850,000 | 100 % |
| Cost of Sales | (730,000) | (730,000)/850,000 | (85.88) % |
| Gross profit | 120,000 | 120,000/850,000 | 14.12 % |
| Administrative expenses | (35,000) | (35,000)/850,000 | (4.12) % |
| Distribution expenses | (12,000) | (12,000)/850,000 | (1.41) % |
| Operating profit | 73,000 | 73,000/850,000 | 8.59 % |
| Interest expense | (11,000) | (11,000)/850,000 | (1.29) % |
| Profit before tax | 62,000 | 62,000/850,000 | 7.29 % |
| Tax | (9,000) | (9,000)/850,000 | (1.06) % |
| Profit after tax | 53,000 | 53,000/850,000 | 6.24 % |
Completed common-size income statement will be without actual figures and workings:
| PakAccountants Inc. | |
| Income Statement as at _________ | |
| % | |
| Sales | 100 % |
| Cost of Sales | (85.88) % |
| Gross profit | 14.12 % |
| Administrative expenses | (4.12) % |
| Distribution expenses | (1.41) % |
| Operating profit | 8.59 % |
| Interest expense | (1.29) % |
| Profit before tax | 7.29 % |
| Tax | (1.06) % |
| Profit after tax | 6.24 % |
With figures expressed in percentages it is extremely easy to understand how much of revenue is consumed by particular expenses and how much is left as profit after tax.
Vertical analysis on income statement is even useful with comparative figures i.e. previous or subsequent year as the following example shows:
| PakAccountants Inc. | ||||
| Income Statement as at _________ | ||||
| 2016 | 2016 | 2015 | 2015 | |
| Sales | 850,000 | 100 % | 960,000 | 100 % |
| Cost of Sales | (730,000) | (85.88) % | (734,688) | (76.53) % |
| Gross profit | 120,000 | 14.12 % | 225,312 | 23.47 % |
| Administrative expenses | (35,000) | (4.12) % | (29,952) | (3.12) % |
| Distribution expenses | (12,000) | (1.41) % | (10,944) | (1.14) % |
| Operating profit | 73,000 | 8.59 % | 184,416 | 19.21 % |
| Interest expense | (11,000) | (1.29) % | (21,898) | (2.28) % |
| Profit before tax | 62,000 | 7.29 % | 162,518 | 16.93 % |
| Tax | (9,000) | (1.06) % | (11,520) | (1.20) % |
| Profit after tax | 53,000 | 6.24 % | 150,998 | 15.73 % |
Interpretation of vertical common-size however, isn’t that straight forward. For example, 23.47% gross profit of 2015 may induce the user to be higher than 14.12% gross profit of 2016 which is not necessarily true. The actual gross profit figure of 2015 may be smaller than 2016 amount but still yield higher percentage.
To relate it with our example above, you can see that cost of sales figure of 2015 is higher than 2016 cost of sales amount but still percentage of 2015 is smaller than 2016’s. Therefore, we can safely say that vertical analysis is only good for within the period analysis and cannot be reliably used to compare straight across periods.
However, we can definitely infer that cost of sales of 2016 have increased in proportion to sales as compared to 2015 and that has affected the gross profit as well. Or in other words, although the revenue has reduced, but cost of sales have not reduced at the same rate as revenue for certain factors like fixed costs that require attention to keep the gross profit percentage stable.
Similarly vertical analysis can also help understand how priorities and strategies might have changed for an entity over a period of or between two different entities.
| Latok I | Gasherburm I | |
| Sales | 100% | 100% |
| Cost of Sales | -50% | -60% |
| Gross Profit | 50% | 40% |
| Admin expense | -10% | -12% |
| Research expense | 0% | -2% |
| Selling expense | -10% | -5% |
| Advertisement expense | -5% | -2% |
| Operating profit | 25.00% | 19.00% |
| Financial expense | -2% | -5% |
| Profit before tax | 23.00% | 14.00% |
| Tax | -2% | -2% |
| Profit after tax | 21.00% | 12.00% |
In the above analysis you can see two different entities with different results. Gasherbrum is relying more on administrative and research activities whereas Latok is saving money with no research and lesser administrative tasks. Also Latok’s higher selling cost seems to justify higher gross profits. It seems Latok’s advertisement strategy is working in its favour.
Gasherbrum on the other hand has higher borrowing cost as well. Considering the limited information available, higher borrowing cost, research expenditures, and falling gross profit may hint upon entity’s struggle to rejuvenate its old product line.
2 Horizontal common-size Income Statement
As mentioned earlier horizontal analysis help determine the proportional fluctuations in items of interest over a period of time. Technically speaking horizontal analysis is more like trend analysis to see how each item has changed over a period of time.
Consider the following example:
| PakAccountants Inc. | |||
| Income Statement as at _________ | |||
| 2016 | 2015 | % Change | |
| Sales | 900,000 | 960,000 | (6.25) % |
| Cost of Sales | (690,000) | (734,688) | (6.08) % |
| Gross profit | 210,000 | 225,312 | (6.80) % |
| Administrative expenses | (35,000) | (29,952) | 16.85 % |
| Distribution expenses | (12,000) | (10,944) | 9.65 % |
| Operating profit | 163,000 | 184,416 | (11.61) % |
| Interest expense | (11,000) | (21,898) | (49.77) % |
| Profit before tax | 152,000 | 162,518 | (6.47) % |
| Tax | (9,000) | (11,520) | (21.88) % |
| Profit after tax | 143,000 | 150,998 | (5.30) % |
Above we have horizontal common-size income statement of same entity based on 2 years.
2016 has been a rough year for PakAccountants Inc. overall. With gross profits plummeting and net profit reducing to one-third of last year things are looking dreary. With the exception of interest expense nothing appears to be going in favour of entity.
All of this could have been easily ignored if we just considered vertical analysis. Following is the common-size income statement with both horizontal and vertical analysis:
| PakAccountants Inc. | |||||
| Income Statement as at _________ | |||||
| 2016 | 2015 | Hor. % | ’16 V % | ’15 V % | |
| Sales | 900,000 | 960,000 | (6.25) % | 100% | 100% |
| Cost of Sales | (690,000) | (734,688) | (6.08) % | (76.67) % | (76.53) % |
| Gross profit | 210,000 | 225,312 | (6.80) % | 23.33 % | 23.47 % |
| Administrative expenses | (35,000) | (29,952) | 16.85 % | (3.89) % | (3.12) % |
| Distribution expenses | (12,000) | (10,944) | 9.65 % | (1.33) % | (1.14) % |
| Operating profit | 163,000 | 184,416 | (11.61) % | 18.11 % | 19.21 % |
| Interest expense | (11,000) | (21,898) | (49.77) % | (1.22) % | (2.28) % |
| Profit before tax | 152,000 | 162,518 | (6.47) % | 16.89 % | 16.93 % |
| Tax | (9,000) | (11,520) | (21.88) % | (1.00) % | (1.20) % |
| Profit after tax | 143,000 | 150,998 | (5.30) % | 15.89 % | 15.73 % |
As you can notice above if we look at vertical analysis and compare the percentages the results seem to be fairly equal and entity has kept everything fairly stable and it seems nothing has really changed.
Rather profit after tax appears to have slightly improved. But don’t forget vertical analysis is comparing each item to the revenue of the same period. Though the revenue of 2016 has decreased, entity has done good job in managing all of the expenses as they have decreased at the same rate. Thus resulting in no relative to revenue fluctuation.
However, the reduction of revenue and overall profitability is evident in horizontal analysis even hinting upon the fact that admin and distribution have rather increased which is quite unnatural considering the fact that revenue and cost of sales has declined meaning the management has failed to manage the business. Thus convincing on the opposite of what vertical analysis was suggesting.