Vertical AnalysisExplained & Defined
What is Vertical Analysis?
Vertical analysis is a method of analyzing financial statements.
Using vertical analysis, every line item on a financial statement is stated as a percentage of a base figure on the statement.
For example, when using vertical analysis on an income statement, all line items can be analyzed as a percentage of net sales.
Understanding Vertical Analysis
Vertical analysis identifies each line item in a financial statement with a base figure.
In a balance sheet, this may mean identifying every line item as a percentage of total assets or for a cash flow statement identifying each cash inflow and outflow to the total outflow for a period.
This type of analysis makes it much easier to compare different companies because it shows the relative size of accounts rather than their balances.
The same applies when looking at the same company over different periods, where it makes it easier to identify trends and determine whether certain metrics are changing for the better or worse.
As an example, a company may choose to look at a vertical analysis of its income statement over several accounting periods and see if certain expenses are contributing to the company’s profitability.
It may also use this analysis to see if its profitability is improving with time and compare its profit margin to those of its competitors.
When using vertical analysis in a financial statement, the base figures will be shown, and then the percentages for each line item will be displayed in a separate column.
When a company releases these types of financial statements with vertical analysis, they are often referred to as common-size financial statements.
When a company releases this type of financial statement, it will often additionally include columns that compare line items to those reported in a previous period for comparison.
Vertical Analysis Versus Horizontal Analysis
Vertical analysis looks at each line item in a company’s financial statements by their relative size in the same period.
In contrast, horizontal analysis looks at line items by how they have changed over a period of time.
Using this method of analysis, an analyst will choose the entries in financial statements from one period to act as a baseline and then present those in other years as changes from that baseline.
Most commonly, this will take the form of percentage changes from the base year.
As an example, suppose a business reported the cash on their December 31 balance sheets for the years 2017, 2018, 2019, 2020, and 2021 as a percentage of their 2017 year-end balance sheet.
This means that instead of recording dollar amounts, they would put percentages, such as 130, 125, 115, 120, and 100.
This would indicate that at the end of the year 2019, the amount of cash the company had was 115% of the cash it had on December 31, 2017.
This would be done for each item listed on the income statement and balance sheet and would allow the business to see how each item changed as compared to other items.
Why Use Vertical Analysis?
- Vertical analysis makes it easy to identify the relative size of the components of a financial statement and their total size. As a result, a company could use this information to establish minimum and maximum limits for individual line items.
- This analysis can also be used to compare a business’s financial statements to the average trends taking place in the industry. Using dollars amounts would not work very well when analyzing an entire industry. But, using common-size percentages can be effective for this purpose, thus allowing for industry comparison.
- This analysis is a very effective way of comparing multiple companies in the same industry that are of different sizes. This method is useful because comparing companies of very different sizes is difficult with a traditional balance sheet. Whereas vertical analysis allows accountants to use common measurements to compare and contrast amounts that are of varying magnitudes in an effective way.
Vertical Analysis Example
As an example, Company X has $10 million in gross sales with a cost of goods sold of $2 million.
They also have selling and administrative costs of $3 million and a 20% tax rate.
The income statement for this business, if they use vertical analysis, would appear as shown below.
Company X Income Statement For Year Ended December 31, 2021 | ||
| Sales | $10,000,000 | 100% |
| Cost of Goods Sold | $2,500,000 | 25% |
| Gross Profit | $7.5 million | 75% |
| Selling and Administrative Expenses | $3,500,000 | 35% |
| Operating Income | $4,000,000 | 40% |
| Taxes (20%) | $800,000 | 12% |
| Net Earnings | $3,200,000 | 32% |
Key Takeaways
- Vertical analysis expresses each item in a financial statement into a percentage of a base figure.
- This method of analysis helps to identify correlations between line items and how they impact overall performance.
- Vertical analysis is particularly useful when used as part of a ratio trend analysis to identify relative changes over a period of time.
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Harvard Business School Online "HOW TO READ & UNDERSTAND AN INCOME STATEMENT" Page 1 . March 28, 2022
California State University "Financial Statement Analysis" Page 1 . March 28, 2022