However, these expenses don't, at first glance, appear large enough to account for the decline in net income. To see exactly what's happening, we'll have to dig deeper. To do that, we'll create a "common size income statement" and perform a vertical analysis. For each account on the income statement, we divide the given number by the company's sales for that year. By doing this, we'll build a new income statement that shows each account as a percentage of the sales for that year. The vertical analysis confirms what we already observed in our initial review of the income statement, and it also reveals the missing driver in ABC Company's net income decline: costs of goods sold.
First, we can see that the company's marketing expenses increased not just in dollar terms, but also as a percentage of sales. This implies that the new money invested in marketing was not as effective in driving sales growth as in prior years. Salaries also grew as a percentage of sales. That's driving a significant decrease in gross profits.
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This change could be driven by higher expenses in the production process, or it could represent lower prices. We can't know for sure without hearing from the company's management, but with this vertical analysis we can clearly and quickly see that ABC Company's cost of goods sold and gross profits are a big issue. Other uses and benefits of a vertical analysis ABC Company's income statement and vertical analysis demonstrate the value of using common-sized financial statements to better understand the composition of a financial statement.
It also shows how a vertical analysis can be very effective in understanding key trends over time.
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The same process applied to ABC Company's balance sheet would likely reveal further insights into how the company is structured and how that structure is changing over time. Another powerful application of a vertical analysis is to compare two or more companies of different sizes. The common-sized accounts of vertical analysis make it possible to compare and contrast numbers of far different magnitudes in a meaningful way. A vertical analysis is also the most effective way to compare a company's financial statement to industry averages.
Using actual dollar amounts would be ineffective when analyzing an entire industry, but the common-sized percentages of the vertical analysis solve that problem and make industry comparison possible.
A useful tool in your analysis toolbox A vertical analysis is excellent at showing what is happening within the financial statements of a company, but it cannot answer the most important question of any analysis: "Why? Ratios help link the three financial statements together and offer figures that are comparable between companies and across industries and sectors.
Ratio analysis is one of the most widely used fundamental analysis techniques. However, financial ratios vary across different industries and sectors and comparisons between completely different types of companies are often not valid. What is a ratio? Financial ratios are no different—they form a basis of comparison between figures found on financial statements. As with all types of fundamental analysis, it is often most useful to compare the financial ratios of a firm to those of other companies. Financial ratios fall into several categories.
For the purpose of this analysis, the commonly used ratios are grouped into four categories: activity, liquidity, solvency and profitability. Also, for the sake of consistency, the data in the financial statements created for the prior installments of the Financial Statement Analysis series will be used to illustrate the ratios. Table 1 shows the formulas with examples for each of the ratios discussed. Activity ratios are used to measure how efficiently a company utilizes its assets. The ratios provide investors with an idea of the overall operational performance of a firm.
As explained in my previous articles, the income statement measures performance over a specified period, whereas the balance sheet presents data as of one point in time. To make the items comparable for use in activity ratios, an average figure is calculated for the balance sheet data using the beginning and ending reported numbers for the period quarter or year.
The activity ratios measure the rate at which the company is turning over its assets or liabilities. In other words, they present how many times per year inventory is replenished or receivables are collected. Inventory turnover is calculated by dividing cost of goods sold by average inventory. A higher turnover than the industry average means that inventory is sold at a faster rate, signaling inventory management effectiveness.
Additionally, a high inventory turnover rate means less company resources are tied up in inventory. However, there are usually two sides to the story of any ratio. Furthermore, inventory turnover is very industry-specific. In an industry where inventory gets stale quickly, you should seek out companies with high inventory turnover. In our example in Table 1 , the inventory turnover ratio of 2. Going forward, a decrease in inventory or an increase in cost of goods sold will increase the ratio, signaling improved inventory efficiency selling the same amount of goods while holding less inventory or selling more goods while holding the same amount of inventory.
The receivables turnover ratio is calculated by dividing net revenue by average receivables. This ratio is a measure of how quickly and efficiently a company collects on its outstanding bills. In Table 1 , the receivables turnover is 7. Alternatively, a low or declining turnover can signal that customers are struggling to pay their bills. Payables turnover measures how quickly a company pays off the money owed to suppliers. The ratio is calculated by dividing purchases on credit by average payables.
Our payables turnover of 5. The payables turnover increases as more purchases are made or as a company decreases its accounts payable. A high number compared to the industry average indicates that the firm is paying off creditors quickly, and vice versa. An unusually high ratio may suggest that a firm is not utilizing the credit extended to them, or it could be the result of the company taking advantage of early payment discounts.
A low payables turnover ratio could indicate that a company is having trouble paying off its bills or that it is taking advantage of lenient supplier credit policies. Be sure to analyze trends in the payables turnover ratio, as a change in a single period can be caused by timing issues such as the firm acquiring additional inventory for a large purchase or to gear up for a high sales season.
Also understand that industry norms can vary dramatically. Asset turnover measures how efficiently a company uses its total assets to generate revenues. The formula to calculate this ratio is simply net revenues divided by average total assets. Our asset turnover ratio of 0.
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A low asset turnover ratio may mean that the firm is inefficient in its use of its assets or that it is operating in a capital-intensive environment. Additionally, it may point to a strategic choice by management to use a more capital-intensive as opposed to a more labor-intensive approach.
Liquidity ratios are some of the most widely used ratios, perhaps next to profitability ratios. They are especially important to creditors. The level of liquidity needed varies from industry to industry. Certain industries are more cash-intensive than others. For example, grocery stores will need more cash to buy inventory constantly than software firms, so the liquidity ratios of companies in these two industries are not comparable to each other. The current ratio indicates if the company can pay off its short-term liabilities in an emergency by liquidating its current assets.
Current assets are found at the top of the balance sheet and include line items such as cash and cash equivalents, accounts receivable and inventory, among others. A low current ratio indicates that a firm may have a hard time paying their current liabilities in the short run and deserves further investigation. A current ratio under 1. In our example, the firm is operating with a very low current ratio of 0.
A high ratio indicates a high level of liquidity and less chance of a cash squeeze. A current ratio that is too high, however, may indicate that the company is carrying too much inventory, allowing accounts receivables to balloon with lax payment collection standards or simply holding too much in cash. The quick ratio is a liquidity ratio that is more stringent than the current ratio.
This ratio compares the cash, short-term marketable securities and accounts receivable to current liabilities.
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The thought behind the quick ratio is that certain line items, such as prepaid expenses, have already been paid out for future use and cannot be quickly and easily converted back to cash for liquidity purposes. In our example, the quick ratio of 0. The major line item excluded in the quick ratio is inventory, which can make up a large portion of current assets but may not easily be converted to cash.
During times of stress, high inventories across all companies in the industry may make selling inventory difficult.
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In addition, if company stockpiles are overly specialized or nearly obsolete, they may be worth significantly less to a potential buyer. Consider Apple Inc.
AAPL , for example, which is known to use specialized parts for its products. If the company needed to quickly liquidate inventory, the stockpiles it is carrying may be worth a great deal less than the inventory figure it carries on its accounting books. The most conservative liquidity ratio is the cash ratio, which is calculated as simply cash and short-term marketable securities divided by current liabilities.
Cash and short-term marketable securities represent the most liquid assets of a firm. Short-term marketable securities include short-term highly liquid assets such as publicly traded stocks, bonds and options held for less than one year. During normal market conditions, these securities can easily be liquidated on an exchange.
The cash ratio in Table 1 is 0. Although this ratio is generally considered the most conservative and very reliable, it is possible that even short-term marketable securities can experience a significant drop in prices during market crises. Some solvency ratios allow investors to see whether a firm has adequate cash flows to consistently pay interest payments and other fixed charges. If a company does not have enough cash flows, the firm is most likely overburdened with debt and bondholders may force the company into default.
The ratio is calculated by dividing total liabilities by total assets.