Business Valuation – Me and Finance

Vertical and Horizontal Income Statement Analysis is used to analyze the income statement. These are performance ratios, which are related to analyzing the profitability of a company. Ratios we use when analyzing a company Profitability Ratios: Here we evaluate the ability of the company to generate income, in relation to balance sheet assets, operating cost, and equity. Efficiency ratios: Here we measure how well the company is utilizing its assets and resources. Financial leverage ratios: Here we measure the amount of capital that comes from debt. These ratios show how liquid and solvent the company is. What is Vertical Analysis? Under vertical analysis, we take each category of the income statement and divide it by Sales revenues (also referred to as "Sales" or "Revenue"). We want to determine how much each category represents as a proportion to the sales revenue. Net income / Sales revenueTax / Sales revenueOperating income / Sales revenueOperating costs / Sales revenueGross Profit / Sales revenueR&D / Sales revenuePersonnel costs / Sales revenueSelling costs / Sales revenueAdmin costs / Sales revenueLabor costs / Sales revenueMaterial costs / Sales revenueWork overhead / Sales revenue Another way to put it is the question, how many cents does each cost category need to incur to produce $1 of sales revenue. When conducting vertical analysis we are usually looking at the income statement of a year. What formulas do we use for vertical analysis? Gross profit margin Gross Profit Margin = Gross Profit / RevenueProfitability ratio expressed as percentage Determines how much is left, after the cost of goods sold. The higher this number is, the better. Operating profit margin Operating Profit Margin = EBIT / RevenueProfitability ratio expressed as percentage This shows what's left to pay to shareholders, the government in form of taxes, and lenders in form of interest. The higher this number is, the more profitable the company is. Net profit margin Net Profit Margin = Net income / RevenueProfitability ratio expressed as percentage This tells us how much income (net earnings) is generated for each 1$ of revenue. The higher this number is, the more profitable the company is. Efficiency ratio Tax Ratio = Tax expense / Income Before TaxEfficiency ratio expressed as percentage By comparing the tax ratio in relation to the tax rate in the jurisdiction, if management is effectively using its assets to generate operating income, or if assets are sitting as idle investments. A tax ratio that is higher than the tax rate, would indicate that assets are idle, as an investment income has a higher tax rate than an operating income. Solvency Ratio Interest Coverage Ratio = EBIT(DA) / Interest expensesEfficiency ratio expressed as percentage This indicates how easy it is for a company to service the interest expense that it has on any debt outstanding, or in other words how many times over, can a company cover its interest expense. The EBITDA version adds back depreciation and amortization, which would be a more aggressive/optimistic approach while EBIT is a more conservative approach. Example of a vertical analysis Income Statement Let's assume we have the following income statement below, for which we want to conduct vertical analysis: ItemYear XRevenueCost of Revenue12,3646,394Gross Profit (Revenue - Cost of Revenue)Selling/General/Administrative ExpensesResearch & DevelopmentDepreciation/AmortizationUnusual Expenses/IncomeOther Operating Expenses, Total5,9701,2807601801100Operating Income (Gross Profit - SG&A, R&D, Depr/Amort, Unusual Exp, Other)Interest Expense3,64080Income Before Tax (Operating Income - Interest Expense)Income Tax3,560810Income After TaxTotal Extraordinary Items2,7500Net Income2,750 Ratios Here we conduct the vertical analysis based on the income statement above. The formulas to reach the percentages are displayed next to the ratio name. The ratio numbers are rounded to full numbers. Gross Profit Ratio (Gross Profit / Revenue)Operating Profit Ratio (Operating Income / Revenue)Net Profit Ratio (Net Income / Revenue)48%29%22%Tax Ratio (Income Tax / Income Before Tax)Interest Coverage Ratio (Operating Income / Interest Expense)29%46% In this example, we see, that the company has an extremely high-interest coverage ratio, which is due to the fact, that the interest payments are extremely low. This tells us that the company has no problem serving the interest expense on its debt. When we look at the Net Profit Ratio, we see that 22% is a pretty good profit ratio. Also the Gross Profit and Operating Profit Ratio's look pretty good for this company. But in order to figure out, how good this company is doing, we need to compare the ratios with other similar companies within the same sector. So we would do the same analysis with other similar companies of this sector and compare the results, to figure out which one is best. This is also known as benchmarking. What is horizontal analysis Horizontal Anysis is a Trend Analysis, in which the ratios are compared month by month, quarther by quarter, or year by year. In order to get a good picture it makes sense to conduct this analysis over 5 or more years. The trend can then be used to predict future performance. When we look at the historic values, we can draw a line that will show us the trend. Trends can be: Consistent growth (line moving up)Consistent decline (line moving down)Exponential growth (line moving up fast in a curve)Exponential decline (line moving down fast in a curve)Flatlined (straight line)Volatility (line showing a zigzag pattern) This allows us to answer questions such as: Are margins rising or falling?Is performance improving or declining?What is causing margins to fall?Are margins impacted by indirect costs? This type of analysis is useful regardless if you are an investor, or a manager of the business. Root-cause analysis We will analyse all the ratios, and after we've determined the trend, we will try to figure out, why we have this trend, by further analyzing the numbers on the income statment (root-cause analysis). Benchmarking In order to determine where the company stands against it's competitors we can use benchmarking. Benchmarking can be done by either comparing several companies within the same industry, or to take the industry average of all the companies. The difficulty with benchmarking is, that there are accounting differences between companies, and there might also be differencies in the way the ratio's are calculated. It can therefore be substantial work to compare the companies to each other.