Vertical analysis is a kind of financial statement analysis wherein each item in the financial statement is shown in the percentage of the base figure. It is one of the popular methods of financial statements as it is simple and also called a common size analysis. Here, all the income statement items are stated as a percentage of gross sales.
Likewise, all the items in the balance sheet are stated as a percentage of the total assets. The opposite of the vertical analysis of financial statements is the Horizontal analysis always looks at the amount from the financial statement over the horizon of many years. The significance of vertical analysis accounting is well-established in businesses irrespective of their size or stature.
Vertical analysis, often referred to as common-size analysis, is a crucial financial tool used in the world of business and finance to assess the relative proportions of different financial statement items.
This method expresses each line item on a financial statement as a percentage of a key benchmark, typically total revenue (in the case of the income statement) or total assets (for the balance sheet). It allows stakeholders, including investors, analysts, and management, to gain valuable insights into a company's financial structure and performance.
In the realm of finance, vertical analysis aids in comparing the composition of income and expenses over time or against industry peers. By converting figures into percentages, it normalizes financial data and makes it easier to identify trends, patterns, and areas of concern. This analysis can uncover whether a company allocates an excessive portion of its revenue to certain costs, such as operating expenses or debt servicing, which can signal inefficiencies or financial risks.
For instance, a vertical analysis of an income statement might reveal that a company is spending a higher percentage of its revenue on marketing expenses compared to its competitors. This could prompt management to reevaluate their marketing strategy or cost structure to enhance profitability.
Therefore, a vertical analysis equation is an indispensable tool in the world of finance and business, enabling stakeholders to gauge a company's financial health, efficiency, and allocation of resources by expressing financial data as percentages relative to a chosen benchmark. This technique fosters informed decision-making and strategic planning, vital for sustained success in today's competitive financial landscape.
In the vertical analysis accounting of financial statements, the percentage is calculated by using the below formula:
Vertical Analysis formula = Individual Item / Base Amount *100
The vertical analysis formula for the Income Statement and Balance Sheet are given below –
Vertical Analysis Formula (Income Statement) = Income Statement Item / Total Sales * 100
Vertical Analysis Formula (Balance Sheet) = Balance Sheet Item / Total Assets (Liabilities) * 100
To increase the effectiveness of vertical analysis, multiple year's statements or reports can be compared, and comparative analysis of statements can be done. This analysis makes it easier to compare the financial statements of one company with another and across the companies as one can see the relative proportion of accounts.
Example of the vertical analysis accounting of the financial statement, which shows the total amount and percentage.
The total sales are $1000000, and the cost of goods sold is $400000. In addition, the salary paid to the workers of the company is $300000, office rent paid is $30000, utilities worth $40000 and other expenses are $60000.
Vertical Analysis Formula = Individual Item / Total Sales * 100
The above vertical analysis example shows the company's net profit where we can see the net profit in both amount and percentage. Where the same report can be used to compare with other industries. The income statement can be compared with previous years, and the net income can be compared where it helps to compare and understand the percentage of rising or loss of income.
The below vertical analysis example helps to understand the comparison.
In the above vertical analysis example, we can see that the income decreases from 1st year to 2nd year, and the income increases to 18% in the 3rd year. So by using this method, it is easy to understand the net profit as it is easy to compare between the years. We can easily understand that the total expenses gradually increased from 43% to 52%, and the net income get reduced from 1st year to 2nd year. In the 3rd year, the COGS decreased compared to the previous years, and the income increased.
Let us now calculate the Vertical Analysis of the Balance Sheet with the help of another example.
Vertical Analysis Formula = Individual Item / Total Assets (Liabilities) * 100
The information provided in the balance sheet provides the change in working capital, fixed income over some time. Where the altered business requires a different amount on the ongoing fund. The same can be done with the income statement, where the previous years can be compared and find out the change in the working capital and fixed assets over time.
Let us understand the advantages of vertical analysis equation through the points below.
Despite the various advantages, there are a few factors of vertical analysis accounting that prove to be a disadvantage. Let us understand them through the explanation below.
Both techniques provide valuable insights for financial analysis and decision-making, but they serve different purposes and offer distinct perspectives on a company's financial performance. Let us understand the differences through the comparison below.
Guide to what is Vertical Analysis. Here we explain its formula, examples, advantages, disadvantages, and compare it with horizontal analysis. You may learn more about financial statement analysis from the following articles –
