Q5RQ - Horngren'S Financial And Managerial Accounting

Question

Question: What is vertical analysis? What item is used as the base for the income statement? What item is used as the base for the balance sheet?

Step-by-Step Solution

Answer

Answer

 

Vertical analysis is used to show the relative size of each item line of the income statement and the balance sheet.

Step 1: Definition of Vertical Analysis

Vertical analysis refers to the comparative analysis of the financial statement in which each line item is represented as a percentage of the base item. The items on the income statement are presented as a percentage of total revenue, and the items on the balance sheet are presented as a percentage of total assets or total liabilities. The vertical analysis of the cash flow statement is made by showing each cash outflow and inflow as a percentage of the total cash inflows.

 

 

Step 2: Overview

Vertical analysis is used to show the relative size of each item line of the income statement and the balance sheet. The total revenue is taken as a base item, and other heads of the income statement are presented as a percentage of the base figure. Vertical analysis is used to analyze the different accounts of the financial statements and describe the changes in the relative size of each item. It is a management tool used by companies in analyzing the changes in the relative size of different accounts over several years. It is also helpful in comparing the financial statements of two companies with the industry average.

 

The formula of Vertical Analysis = (Individual Item/ Base item) *100

Step 3: What item is used as the base for the income statement?

In the case of the Income Statement, the base should be taken as the Total Sales Amount.

So, the formula will be = (Income Statement item/ Total Sales)*100

For example, suppose in Income Statement COGS is $400,000 and sales is $1,000,000 then, in that case, COGS percentage is 40% is computed by dividing COGS amount of $400,000 with the base item of Sales i.e. $1,000,000.

 

Step 4: What item is used as the base for the balance sheet?

In the case of the Balance Sheet, the base should be taken as Total Assets(Liabilities).

So, the formula will be = (Income Statement item / Total Assets(Liabilities))*100

For Example, Current Assets are given as $550,000 and Total Assets are $1,139,500

So in that case Current year Percentage of 48.3% is computed by dividing the current assets amount of $550,000 by the base item of $1,139,500

balance sheet item