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In the dynamic world of finance, where strategic decisions shape the course of businesses, mastering vertical analysis can help you simplify your statement, make critical financial decisions, and understand the underlying composition and trends that drive your business’ financial performance.
Vertical analysis evaluates financial statements that will help you simplify a document containing complex numbers and figures.
This blog will guide you on what vertical analysis is, how to perform it, and how it can help your business to scale through data-driven decisions.
What Is Vertical Analysis?
Vertical analysis is a method of financial analysis where each line item is listed as a percentage of a base figure within the statement.
For vertical analysis, you break down the financial statement into categories like revenue and expenses and then calculate the percentage that each category represents out of the total. This enables you to list the percentage of each item against the company’s gross value. It helps you to easily assess the company’s cash flow in terms of the total. Why Use Vertical Analysis?
Vertical analysis provides insights into the composition of your financial statements and their relationship with the base amount. Also known as the vertical percentage analysis, you can then use this to evaluate company performance and compare it with previous results to understand the direction of your company.
This financial analysis can help you build a solid financial report by comparing the percentages to the budgeted expectations.
In the context of vertical analysis, consider an instance where you aim to comprehend the contribution of each line within your financial statement towards generating revenue. In this scenario, revenue serves as the fundamental component, and the percentages will unveil the proportion of revenue generated by each specific item.
This information will provide a better understanding of which areas of your company are generating high and low revenue. This analysis helps see the proportion of each item compared to the net profit, providing insights into where the money is coming from and where it is being spent.
Importance of Vertical Analysis in Financial Reporting
Vertical percentage analysis provides a swift means of evaluating your past performance by comparing your current figures to those of the past. This approach enables you to summarize the operational status of your business.
You simply receive a concise view of your line items without performing complex calculations. Using tools such as Power BI to chart your results, you can visualize your performance and make informed decisions for a successful plan.
Utilizing tools in conjunction with vertical common size analysis significantly helps with financial reporting. It enables businesses to gain quick insights into historical performance by comparing current values to previous periods. You can then get a summary of how the business is operating and performing over time.
Furthermore, by accessing up-to-date data, you can make informed decisions based on a comprehensive understanding of your financial performance. The ability to create charts, graphs, and visual representations of financial data simplifies the planning process and enhances decision-making capabilities.
A Step-by-Step Guide to Performing Vertical Analysis
Performing vertical common-size analysis is a relatively simple process. Before conducting vertical analysis, having all the data needed for the calculation is critical. You can use data aggregation tools to help you build a statement.
Here is a simple guide on how you can perform vertical analysis:
1. Select the Financial Statement
When conducting vertical analysis, individuals often rely on specific financial statements such as balance sheets, income statements, and cash flow statements. Each of these statements offers unique perspectives on a company’s financial situation. For instance, an income statement reveals gross sales figures, a cash flow statement presents total assets and revenues, and a balance sheet displays the total liabilities and assets.
Would you like to review the financial performance from the past months/years or demonstrate your business’s financial health to stakeholders? Recognizing the objective will assist you in determining the appropriate foundation for your calculations.
2. Use the formula
You can now plug the numbers into the vertical percentage analysis formula:
(Line item/ base amount) x100
Here, the line item is the item you want to analyze compared to the base amount. This figure can then be multiplied by 100 to produce the percentage.
3. Chart the numbers
Input the percentage against the line items calculated to see a concise view of each item’s contribution to the gross amount. Creating visually appealing charts such as bar graphs or data tables will make it easier to understand.
Once you’ve incorporated the results, the remaining percentage will be your net profit/loss for that year.
Examples of vertical analysis in action
#1: Income Sheet Analysis
Income Statement of ABC Corporation:
|Cost of Goods Sold||$200,000|
To perform vertical analysis, we express each line item as a percentage of net sales. Net sales will be our common base, and we’ll calculate the percentage for each line item accordingly:
|Sales||$500,000 / $500,000||100%|
|Cost of Goods Sold||$200,000 / $500,000||40%|
|Gross Profit||$300,000 / $500,000||60%|
|Selling Expenses||$50,000 / $500,000||10%|
|Administrative Expenses||$30,000 / $500,000||06%|
|Income||$220,000 / $500,000||44%|
|Interest Expense||$20,000 / $500,000||04%|
|Net Income||$200,000 / $500,000||40%|
In this example, we calculated each line item’s percentage relative to net sales. This allows analyzing the composition of the income statement and understand the relative significance of each item in relation to the company’s revenue.
For instance, we can observe that the cost of goods sold represents 40% of net sales, indicating that the production or procurement of goods consumes 40% of the revenue. The gross profit margin is 60%, suggesting that the company retains 60% of its revenue after deducting the cost of goods sold.
Furthermore, the operating expenses, such as selling and administrative expenses, account for 10% and 6% of net sales, respectively. This helps identify the proportion of revenue allocated to these specific expenses. Finally, the net income margin is 40%, indicating that 40% of the company’s net sales translates into net income.
#2: Balance Sheet Analysis
Company XYZ Balance Sheet
As of December 31, 2022
|Cash and Cash Equivalents||$50,000 (10% of total assets)|
|Accounts Receivable||$100,000 (20% of total assets)|
|Inventory||$200,000 (40% of total assets)|
|Property, Plant, and Equipment||$150,000 (30% of total assets)|
|Accounts Payable||$75,000 (15% of total liabilities and equity)|
|Long-Term Debt||$100,000 (20% of total liabilities and equity)|
|Common Stock||$200,000 (40% of total liabilities and equity)|
|Retained Earnings||$125,000 (25% of total liabilities and equity)|
|Total Liabilities and Equity||$500,000|
In this vertical analysis, we express each item on the balance sheet as a percentage of the total assets (for assets) or total liabilities and equity (for liabilities and equity). This helps us understand the composition of the balance sheet and identify any significant trends or deviations.
Some observations based on the vertical analysis:
- Cash and Cash Equivalents represent 10% of total assets, indicating a relatively lower level of liquidity compared to other assets.
- Accounts Receivable represents 20% of total assets, which suggests that the company has a significant portion of its assets tied up in outstanding customer invoices.
- Inventory represents 40% of total assets, indicating a relatively high level of inventory compared to other assets. This might suggest potential issues with inventory management or slow inventory turnover.
- Property, Plant, and Equipment represent 30% of total assets, implying a significant investment in long-term productive assets.
- Accounts Payable represents 15% of total liabilities and equity, indicating that the company relies partially on trade credit for financing its operations.
- Long-Term Debt represents 20% of total liabilities and equity, indicating a moderate level of debt financing.
- Common Stock represents 40% of total liabilities and equity, suggesting that equity financing has a significant contribution to the company’s capital structure.
- Retained Earnings represent 25% of total liabilities and equity, indicating the company’s historical profitability and reinvestment of earnings.
By performing vertical analysis, businesses can gain insights into the relative composition of their income statement, identify areas of cost control or improvement, and assess the financial performance in relation to revenue.
What Is Horizontal Analysis?
Horizontal analysis compares line numbers over a period of time. Instead of determining the percentage of each line number against the base figure over a particular year, you can establish the change of each line number over a period of years.
Using historical data, you use a baseline year (not item) to determine each line’s percentage/absolute number.
Vertical analysis vs. horizontal analysis
Horizontal and vertical analysis allow you to develop strategies based on trends you find in your financial statement. However, the two are very different, and here’s how:
|Vertical Analysis||Horizontal Analysis|
|1||Performed vertically inside a column||Performed horizontally across periods|
|2||Represents amounts as percentages of the base figure||Represents changes over the years/periods of each line item|
|3||Focuses on one reporting year||Examines many reporting periods|
|4||Compares one company’s financial status to another||Compares a company’s financial status to its own past status|
Advantages and Limitations of Vertical Analysis
- Easier analysis: You receive a snapshot of your financial health and the areas needing your attention. Expressing each item as a percentage can be easily understood and interpreted for analyzing the company’s performance.
- Help identify trends: Vertical analysis can help you find the trends in your financial statement and understand which items have faced a steady increase or decrease over time. By evaluating trends of certain items over a period of time, you can use the insights to enhance your financial strategy.
- Comparing companies: Vertical analysis can allow you to compare two or more companies in the same industry. Once you’ve evaluated the percentage of each line item, you can compare the results with other companies and evaluate the strategy to better your performance.
- Lack of context: Let’s say you increased the cost of production, and you’re measuring this against the base value (total sales). You can only understand the percentage of production cost on the sales through vertical analysis. You will not consider how increased sales might have led to increased production cost.
- Assumes stability: Vertical analysis assumes the expense and revenue remain stable over time, which is not always the case. This reduces reliability for companies with fluctuating cash flow.
- Over-simplification: While simplification is the benefit of vertical analysis, it can also be considered a limitation mainly because it doesn’t factor important reasons for a line item’s percentage. For example, if you’re looking at the cost of production again, your percentage will not consider the development effort or importance of the product.
How Vertical Analysis Helps In FP&A
Vertical analysis is the critical tool in FP&A that provides valuable insights into the relative importance of different items within the financial statements and their impact on overall performance. You can use vertical page analysis on income statement (income statement analysis) or balance sheet (balance sheet analysis).
Here is how vertical analysis can benefit FP&A:
Assess cost and expense allocation
Income statement analysis can help you analyze the distribution of costs and expenses relative to revenue. This helps in evaluating the efficiency of cost management which thus identifies areas of improvement. For example, if a specific expense item is consistently increasing as a percentage of revenue, it may indicate a need to optimize costs or explore opportunities for expense reduction.
Evaluate balance sheet composition
When you apply vertical analysis to the balance sheet, you can understand the relative composition of assets, liabilities, and equity. Through accounting ratios, you can compare two-line items in your financial statement and point which items are bringing in more profit. By examining the proportional changes in these components, you can evaluate the company’s financial structure, liquidity, and leverage. It helps identify the impact of changes in asset or liability categories on the overall financial health of the organization.
Forecasting and scenario analysis
Through vertical percentage analysis, you can also forecast future financial performance. Understanding the relationship between different line items within the financial statements can provide FP&A professionals to make assumptions about the future composition and allocate resources accordingly. This analysis can be particularly useful when performing scenario analysis to assess the potential impact of different strategies or market conditions on the company’s financials.
Vertical common size analysis provides a valuable tool for FP&A professionals to gain insights into the composition, trends, and relationships within a company’s financial statements. Through FP&A tools, you can simplify vertical analysis by conducting faster calculations, incorporating the values into visually appealing charts, forecasting your company’s future through analysing historical data.
Vertical analysis is an invaluable tool for simplifying financial statements and gaining valuable insights into a company’s financial performance. Acterys takes the effectiveness of vertical analysis to the next level with its advanced features and capabilities. By seamlessly integrating data from multiple sources, converting it into a suitable format, and offering dynamic reporting and visualization options, Acterys streamlines the vertical analysis process.
With Acterys, FP&A professionals can conduct thorough vertical analysis and make well-informed decisions thanks to its scenario planning and collaboration features. This empowers organizations to drive business growth by unlocking the true potential of their financial data and harnessing the advantages of vertical analysis for strategic decision-making.
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- Vertical analysis is a financial analysis method that expresses each line item in a financial statement as a percentage of a base figure within the same statement.
- Vertical analysis allows businesses to evaluate a company’s financial performance, tracking trends over time and comparing current results to past data. It provides quick insights into the composition of financial statements and helps in budgeting and decision-making.
- To perform vertical analysis, select the financial statement you want to analyze, calculate the percentage for each line item relative to the base amount, and visualize the results using charts or graphs.
- Vertical analysis focuses on one reporting year and expresses items as percentages, while horizontal analysis examines changes over multiple reporting periods. Both methods are valuable for financial analysis but serve different purposes.
- What is the formula for vertical analysis?
(Line item/ base amount) x100
- How is vertical analysis used in financial analysis?
Vertical analysis is used on a balance sheet, income statement, and cash flow statement and is used to understand each line item as compared to the base amount. You can use this to compare companies of different sizes and their financial statement to averages.
- What is the importance of vertical analysis in accounting?
Vertical analysis lets you identify trends, growth areas, and patterns in your financial statements and build well-informed strategic plans.
- How can vertical analysis be used to compare companies in the same industry?
You can compare companies in the same industry by standard comparisons of key line items. By comparing other companies’ percentages against your own, you can understand the strengths, weaknesses, and changes you will need to make.