Last updated on August 13th, 2024 at 08:35 am
In the world of finance, understanding how to interpret financial statements is crucial. One useful technique is vertical analysis. This method helps you look at the bigger picture and identify trends over time. Whether you're a seasoned finance professional or just starting, mastering vertical analysis can provide significant insights into a company's financial health.
In the income statement, the base figure is usually total sales or revenue. For the balance sheet, the base could be total assets or total liabilities and equity. By converting absolute numbers into percentages, vertical analysis helps highlight the relative proportions of each item.
What Is Vertical Analysis?
Vertical analysis is a technique used in financial reporting where each line item is expressed as a percentage of another item in a financial statement. Each line item in an income statement, for instance, might be represented as a percentage of overall sales. This facilitates the comparison of financial accounts between organizations of all sizes and over different periods.
How Vertical Analysis Works
Vertical analysis simplifies comparing financial statements between companies and industries by showing the relative proportions of account balances. It's also great for comparing different periods, making it easier to see if performance is getting better or worse over time.
Here's how it works:
- Comparing Companies: By converting each item on a financial statement to a percentage of a base figure (like total sales), you can easily compare one company to another, regardless of their size.
- Time Series Analysis: This method lets you look at financial data over several years. You can compare quarterly or annual figures to see trends and determine if the company's performance is improving or declining.
- Profit Margins: For example, in an income statement, if you show various expenses as a percentage of total sales, you can see how much each expense contributes to the profit margin. This helps in comparing profitability over time and against other companies.
Financial statements using vertical analysis clearly show the percentages in a separate column. These are also known as common-size financial statements. Many companies use these to give a detailed view of their financial position.
Common-size financial statements often include comparative data, showing each line item compared to previous periods. This provides a clear picture of changes and trends over time.
What are the Benefits of Vertical Analysis?
There are several benefits of vertical analysis in financial reporting:
- Simplified Comparison: It allows for easy comparison across different periods or companies by standardizing financial data.
- Trend Identification: By looking at percentage changes over time, you can identify trends and see how certain costs or revenues are evolving.
- Highlighting Significant Changes: Significant changes in percentages can quickly draw attention to areas that need further investigation.
- Better Decision-Making: With a clearer understanding of where money is coming from and where it's going, better financial decisions can be made.
How to Conduct Vertical Analysis?
- Choose a Base Figure: For an income statement, this is typically total sales. For a balance sheet, it could be total assets or total liabilities and equity.
- Convert to Percentages: Divide each line item by the base figure and multiply by 100 to get a percentage.
- Analyze the Results: Look at the percentages to understand the relative size of each item.
Vertical Analysis vs. Horizontal Analysis
Vertical analysis and horizontal analysis are two key methods for evaluating financial statements. Here's a simple breakdown of how they differ and what each one is used for.
Key Differences
- Vertical Analysis: This method shows each line item as a percentage of a base figure (like total sales or total assets). It helps in understanding the relative size of each item.
- Horizontal Analysis: This method looks at the percentage change of each line item from one period to the next (quarter over quarter or year over year). It helps in spotting trends over time.
Even though vertical analysis doesn't show changes over time directly, you can still compare the percentages of line items from different periods to see trends.
Vertical Analysis Examples
Let's look at how vertical analysis works using an income statement with expenses over two years.
Analysis:
- Sales Increase: Total sales increased from $850,000 to $1,000,000.
- Profit Margins: The gross profit percentage dropped from 75% to 70%, and the net profit percentage decreased from 34.70% to 28.65%.
- Cost of Goods Sold: The cost of products sold went up from 25% to 30% of total sales.
Even though the company made more money in sales in Year 2, the increased cost of goods sold led to lower profit margins.
Vertical Analysis in Different Financial Statements
Vertical analysis is a useful method for examining different types of financial statements. Here's how it works for various financial documents:
Income Statement
In an income statement, vertical analysis shows each line item as a percentage of total sales. This helps you see how much of the sales revenue is being spent on costs like the cost of goods sold, salaries, rent, & other expenses. For example, if COGS is 30% of sales, you know that 30 cents of every dollar earned goes to producing goods.
Balance Sheet
For a balance sheet, vertical analysis shows each item as a percentage of total assets or total liabilities & equity. This helps you understand the composition of a company's assets and how they are financed. For instance, you can see what percentage of total assets are current assets (like cash & inventory) versus long-term assets (like property and equipment).
Cash Flow Statement
Though less common, vertical analysis can also be applied to a cash flow statement. Here, each line item is shown as a percentage of total cash inflows or outflows. This helps you see where the money is coming from and how it is being spent. For example, you can see what percentage of total cash outflows is used for operating activities versus investing or financing activities.
The Final Words
Vertical analysis is a powerful tool for interpreting financial statements. By converting numbers into percentages, it provides a clear picture of a company's financial structure and trends over time. Whether comparing different periods or different companies, this technique simplifies the process and highlights key areas for further analysis.
Mastering vertical analysis is a valuable skill for anyone pursuing a career in finance. It's commonly used in various roles, such as financial analysts, accountants, auditors, and finance managers. Understanding techniques can improve your ability to analyze financial statements, make informed decisions, and communicate financial health to stakeholders.
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