# Mini-Video – Accounting 2 – Chapter 17 Financial Statement Analysis – Vertical Analysis

-Let's take a look at vertical analysis, now
vertical is up and down, right? Vertical analysis is when we focus on the
relationship on a financial statement at a given point in time, okay? And we express each item as a percentage of
a certain amount, okay? The base amount that we use for the balance
sheet vertical analysis is total assets. The base amount that we use for the income
statement is usually total sales. This is going to be best illustrated with
an example so let's look at a fictitious company here, Highland Corporation, for two years.

And let's do common-size statements, in other
words, vertical analysis. Okay, well, here is their two years of data,
just looking at two years for time sake here, okay? Well, we're gonna take every number divided
by the sales for that year, okay? So, this 69.2 is achieved by taking the 360,000
divided by the 520,000, okay? This 65.6% is a way of saying that cost of
goods sold for 2013 was 65.6% of sales and we got that by taking 315,000 divided by 480,000
and you do that for each item, okay? Now this is just a real quick example but
what conclusions can we draw? Well one thing that would jump out to me right
here is I would do horizontal analysis of our vertical analysis computations.

Let me say that again. I would do horizontal analysis over time of
those vertical analysis computations and one thing that would alarm me a little bit is
their gross, oh sorry, I circled the wrong one. Circled the wrong one, sorry. This is the one I meant to circle, okay? One thing that would alarm me here is that
their gross margin percentage declined from 34.4% to 30.8%, that's not good, is it? That's a big decrease in gross margin percentage,
okay? So I don't know what's happening there but
it tells us where we need to investigate. Is the cost of our goods that we sell increasing
and we're not able to pass those on to the customer or we're just not passing them on
to the customer, or what? But our margin is eroding, you see that? Okay. We take everything divided by sales for the
year to get all of these numbers. As I said, horizontal analysis of vertical
metrics is a powerful tool and perhaps you see that gross profit percentage is declining
over time or if you do net income divided by sales, it is declining over time, okay? When I did this, this is horizontal analysis
over time of a vertical measurement, isn't it? And you can see that whoever this person is,
he is getting quite large, right? Okay.

Address the situation before they have a heart
attack and die, right? Okay? Seriously, I said this before, we want to
try to solve problems while they're still solvable, that's why we use these metrics
and why we use this analysis, okay? Back to the computer. Some real-world examples of when this was
used. Subway did this sort of analysis back in '08
and they realized they had an advantage in their margin due to their low food costs and
what they enacted was the \$5 Footlong campaign. And they did have a decrease in margins but
from their analysis they knew, or they suspected, that it would be more than offset by volume
increases and they were correct, total net income increased. Now Quiznos tried to follow suit but they
had a lower gross margin because their food costs were much higher.

They tried to do the same sort of strategies
as Subway and their margins eroded and they could not make them up in increased volume
and a lot of franchises actually went out of business, okay, including the one that
I liked to go to, okay? So this is a quick example of how this has
been used in real life, okay? On a balance sheet, we do vertical analysis
but we take everything divided by the total assets, okay? That is the base number we use and you can
see this right here.

Every one of these numbers were divided by
total assets to get whatever number it is, okay? Now something like this is so much easier
if you know how to use Microsoft Excel, okay? If you take Managerial Accounting from me,
you'll learn how to use Microsoft Excel if you don't know already, okay? And then of course we can a lot of times use
a, make a circle graph out of some of this data as well and that can be used in our analysis
purposes as well..