Vertical Analysis
September 10, 2021
What is “Vertical Analysis”?
Vertical analysis is a method of financial statement analysis in which each line item is shown as a percentage of the base figure. It is most commonly used within a financial statement for a single reporting period. When we carry out vertical analysis on the income statement, it shows the top-line sales figure as 100% and every other item is shown as percentage of the total sales for that year. Each item in the income statement is divided by the company’s total sales for that year (which gives us a common size income statement).
In the case of a balance sheet, the total assets of a company will be shown as 100%, while all other items in the assets and liabilities sections are shown as a percentage of the total assets for that year (which gives us a common size balance sheet).
Key Learning Points
- The vertical analysis formula translates each item in the income statement and the balance sheet into a percentage of total sales and total assets respectively
- There are five key advantages of carrying out vertical analysis of the financial statements of a company or companies
Vertical Analysis – Formula
To calculate the percentage for the vertical analysis of financial statements – with reference to the income statement and the balance sheet, the formulas are:
Vertical Analysis (Income Statement) = Item in Income Statement/Total Sales * 100
Vertical Analysis (Balance Sheet Statement) = Item in Balance Sheet/Total Assets * 100
Advantages of Vertical Analysis
Deeper composition insights
Vertical analysis enables the analyst to delve deeper into a financial statement and better comprehend its composition. To perform such analysis, one needs to create a common size financial statement (for example, a common size income statement).
Key trend analysis
Vertical analysis of financial statements is also very useful in analyzing key trends over time. For example, through vertical analysis, we can assess the changes in the working capital or fixed assets (items in balance sheet) over time.
Multi-year comparisons
Multiple year financial statements can be compared and comparative analysis of such statements can be carried out to enhance the effectiveness of vertical analysis. Such analysis provides us with comparable percentages that can be used for comparison of financial statements with the previous years.
Cross-company analysis
With vertical analysis, one can compare and contrast the financial statements of one company with another, or across various companies. When each income statement or balance sheet item is given as a percentage of total sales and total assets respectively, one can view and compare the relative proportion of each item across companies. This helps in assessing relative profitability, efficiency and competitiveness among other factors over time.
Financial statement composition
Lastly, one can evaluate the structural composition of items from the company’s financial statements – for example of assets, liabilities, expenses etc.
Vertical Analysis – Example
Given below is an example, where we have the income statement of a company (in US dollars). We can gather from the data below that the sales of the company increased consistently from year 1 to year 3. However, while sales rose consistently from year 1 to 3, net income dropped markedly in year 3 so we would like to look into this in more detail.
Given the consistent sales growth from year 1 to year 3, it is not surprising that salaries and the marketing expenses of the company have also risen as personnel and marketing spend generally supports sales growth. However these expenses, at the first glance, don’t seem to be significant enough to account for the large fall in net income in year 3. This is where vertical analysis proves to be useful.
The first step of vertical analysis is to make a new income statement, such as the common size income statement stated below. Here, we have divided each item by the company’s total sales and shown each category as a percentage of total sales for year 1-3 respectively.
We can discern through vertical analysis that the main problem area vis-à-vis the decline in net income in year 3 is the cost of goods sold. This rose sharply to 52% of sales in year 3 (from 41% and 44% in year 2 and year 1 respectively). As a result, there was a significant fall in gross profits in year 3.
As noted before, we can see that salaries increased to 22% as a percentage of total sales in Year 3, compared to 20% in year 2. We can also view from this table that marketing expenses as a percentage of total sales increased to 8% as a percentage of total sales in year 3, compared to 6% in year 2. However, these two types of expenses did not really rise substantially and only account for a relatively small proportion of revenue.
We must also consider that there may be another factor responsible for the significant rise in total sales in year 3 – such as a robust economy driving significantly higher sales in this year. This may be due to higher demand or some other factor that needs to be investigated.
By using vertical analysis we can look at the proportional contribution of each cost (COGS, marketing, salaries, etc) and analyze which are having a significant impact on profitability. It is a simple and consistent method that can be used year on year and also compare different companies. By being able to measure which cost areas of the business are rising (falling) as a proportion of sales, one can then look at the contributing factors in more detail.
Conclusion
Vertical analysis is a powerful tool for financial statement analysis that allows for a deeper understanding of a company’s financial composition. By converting each item in the income statement and balance sheet into a percentage of total sales and total assets, respectively, it provides valuable insights into key trends, multi-year comparisons, and cross-company analysis. This method helps in identifying significant impacts on profitability and enables a consistent approach to measure cost areas of the business over time. Vertical analysis proves to be an essential technique for evaluating the structural composition of financial statements and making informed financial decisions.