Balance Sheet Vertical Analysis: What It Is and How It Works

Vertical analysis helps assess a company’s financial performance and efficiency by examining the proportions of key line items. You can identify trends, analyze the impact of specific expenses or revenue sources, and evaluate profitability ratios using vertical analysis. For example, if the cost of goods sold has a history of being 40% of sales in each of the past four years, then a new percentage of 48% would be a cause for alarm. The primary difference between vertical analysis and horizontal analysis is that vertical analysis is focused on the relationships between the numbers in a single reporting period, or one moment in time. Horizontal analysis allows investors and analysts to see what has been driving a company’s financial performance over several years and to spot trends and growth patterns.

Strategic benefits of vertical analysis for FP&A Leaders

For example, it can help identify if a company’s accounts receivable has steadily increased over the past three years, which could indicate a problem with credit and collection policies. In this example, we have expressed each line item as a percentage of the revenue, which serves as the base figure. By doing so, we can analyze the proportions and relationships between different components of the income statement. While horizontal analysis remains valuable for assessing changes over time, vertical analysis offers unique perspectives and granularity in financial analysis. Vertical analysis makes it much easier to read and compare the financial statements of one business to another.

By grasping the purpose, importance, and various components of vertical analysis, you can harness its full potential in financial analysis and decision-making. In this guide, we will explore the concept of vertical analysis, its purpose, and why it is crucial in financial analysis. We’ll dive into the methodology of vertical analysis and walk you through the step-by-step process of conducting a vertical analysis. By the end of this guide, you’ll be equipped with the knowledge to interpret vertical analysis results and apply them in practical scenarios. When looking at the financial statements of your business, it can get quite confusing due to the different figures used.

The significance of vertical analysis accounting is well-established in businesses irrespective of their size or stature. These examples demonstrate how vertical analysis allows for meaningful comparisons, identification of trends, and assessment of the relative proportions and relationships within financial statements. By applying vertical analysis to real-world scenarios, you can unlock valuable insights and make informed decisions based on the financial health and performance of a company. Vertical analysis is used in order to gain a picture of whether performance metrics are improving or deteriorating.

This type of question guides itself to selecting certain horizontal analysis methods and specific trends or patterns to seek out. Last, a horizontal analysis can encompass calculating percentage changes from one period to the next. As a company grows, it often becomes more difficult to sustain the same rate of growth, even if the company grows in pure dollar size. This percentage method is most useful when identifying changes over a longer period of time where there may be significant deviations from the base period to the current period.

Vertical Analysis Methodology

If a company’s net sales were $2 million, they will be presented as 100% ($2 million divided by $2 million). 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.

Exploring the Vertical Analysis of Operating Cash Flows

• The profit and loss statement’s vertical analysis helps to determine how each item of income and expense affected the size of the profit.
• Use the insights gained from the vertical analysis in your decision-making processes.
• It works by listing each line item as a percentage of a base figure within the financial statements in question.
• This implies that the new money invested in marketing was not as effective in driving sales growth as in prior years.
• Here, all the income statement items are stated as a percentage of gross sales.
• When used together, they offer a comprehensive view of the company’s financial health.

Vertical analysis shows the structure of enterprise funds and their sources. If you were to compare the two different years using the vertical analysis percentage, you can see what changes have been made and whether or not they were beneficial for the business. If a percentage of an expense, for instance, was very high, it could be a sign that the company is not using their resources efficiently and should investigate how they can lower that cost. 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.

Vertical Analysis – Formula

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. 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.

Vertical Analysis Tools and Software

When used together, they offer a comprehensive view of the company’s financial health. Vertical analysis provides a better understanding of how each line item on the balance sheet fits into the company’s financial structure and vertical analysis definition is an invaluable decision-making tool. Here, the Total Revenue is considered 100%, and all other figures are expressed as a percentage of this total. This vertical analysis shows that the company’s Cost of Goods Sold is 40% of the total revenue, leaving a gross profit margin of 60%.

• Despite the benefits and insights that vertical analysis can provide, it’s essential to acknowledge its limitations and drawbacks.
• By comparing the percentages of line items, you can identify areas of strength or weakness and gain insights into competitive positioning.
• By stacking crops vertically, farms can produce more food in a smaller area.
• Example of the vertical analysis accounting of the financial statement, which shows the total amount and percentage.
• This type of comparison is most often used to spot high-level, easily identifiable differences.

Over three years, you might notice salaries increasing from 31% to 42% of revenue. Since vertical analysis presents results as percentages, it’s clear that salaries are rising in relation to revenue changes. Vertical analysis streamlines financial analysis, offering a clear and concise view of the most significant financial metrics. For finance and FP&A leaders, it’s a great way to quickly spot any problem areas or parts that need a bit more attention, making their job a bit simpler and more focused. Quickly surface insights, drive strategic decisions, and help the business stay on track. Understanding these key components is vital to the successful execution and interpretation of vertical analysis.

How to Perform a Vertical Analysis on Your Balance Sheet

To find the vertical analysis, you simply divide each line of the balance sheet by your base figure. If the income exceeds the expenses, then the organization made a profit in the reporting period. If expenses exceed income, then the organization received a loss in the reporting period. Vertical analysis of income provides for the determination of the share of each item in the final profit (loss) indicator.

The same process applies, except the most commonly used denominator is total assets. Through careful interpretation of vertical analysis results, you can gain valuable insights into a company’s financial performance, strengths, and areas for improvement. The income statement, also known as the profit and loss statement, reveals a company’s revenues, expenses, and net income over a specific period. It highlights the profitability of the business and helps assess its operational efficiency. For example, upper management may ask “how well did each geographical region manage COGS over the past four quarters?