Definition
Vertical Analysis is a financial method in which each entry for a certain category of a financial statement is represented as a percentage of the total account. For instance, in an income statement, each line item may be represented as a percentage of gross sales. This method presents a clear picture of the relative proportion of different elements and aids in identifying trends over time.
Key Takeaways
- Vertical Analysis is a method of financial statement analysis where each item is listed as a percentage of a base figure within the same period. This technique allows for easier comparison and comprehension of the company’s financial health.
- It predominantly serves as a tool for internal comparison over different periods, showcasing shifts and trends within a company’s performance. For instance, by representing all items in a balance sheet as a percentage of total assets, or all items in an income statement as a percentage of sales.
- Vertical Analysis can also be used for comparison among different companies, by making diverse sized companies more comparable. However, it’s essential to remember that the comparison should be among companies in the same industry, as industry norms can affect the figures significantly.
Importance
Vertical analysis is an important concept in finance because it allows an assessment of a company’s financial health in a standardized and straightforward manner.
It provides an in-depth look at a company’s financial statement, such as the income statement or balance sheet, by expressing each item as a percentage of a certain base number.
This method is particularly valuable because it allows businesses to easily compare their financial condition and performance to other companies of different sizes within the same industry.
By focusing on ratios and percentages rather than absolute numbers, vertical analysis helps identify trends over time, and aid in pinpointing inefficiencies or potential areas of concern within the company’s financial structure.
Explanation
Vertical analysis, often referred to as common-size analysis, is a financial method that is utilized to express each item in a financial statement as a percentage of a base figure. This purposeful approach allows for a straightforward percentage comparison of all individual line items to a specific base, which is typically total assets for a balance sheet and net sales for an income statement.
The primary objective is to prepare a straightforward and organized company’s financial statement that clearly communicates a proportionate absolute comparison. This technique is frequently used during financial statement analysis where each entry for each major category of accounts, or line item, in a financial statement is represented as a proportion of the total account balance.
For instance, on an income statement, each line item would be stated as a percentage of gross sales or revenue, and on a balance sheet, each item would be calculated as a percentage of total assets or total liabilities plus shareholder equity. By conducting vertical analysis, businesses can study trends, compare their financial stature with competitors, and evaluate efficiency in operations.
Examples of Vertical Analysis
Company Financial Reports: Corporations often utilize vertical analysis in presenting their annual financial reports. For instance, a company like Apple may express each line item on its income statement as a percentage of total sales. This allows stakeholders to identify trends over time and evaluate the organization’s financial performance, such as a significant variance in cost of goods sold or operating expenses as a percentage of sales compared to previous years.
Efficiency Comparison: For instance, a retail chain like Walmart uses vertical analysis for comparing the efficiency of its different sectors. With this analysis, they might assess the amount each store contributes as a percentage of total company sales and establish performance trends. This way, they can see which stores underperform or overshoot expectations and control business aspects such as operations, inventory, and pricing accordingly.
Evaluating Profitability: In the hotel industry, a business like Marriott may use vertical analysis when assessing its profit margins. The main types of incomes for hotels are room income, restaurant income, and other income (such as conference hall rentals). By treating total income as 100%, they can measure what percentage each income type represents and how it affects the overall profits, enabling them to potentially re-allocate resources or re-strategize to maximize profits.
FAQs on Vertical Analysis
What is Vertical Analysis?
Vertical Analysis is a method of financial statement analysis in which each line item is listed as a percentage of a base figure within the statement. In other words, it’s a technique where individual line items on a specific company’s financial statement are represented as the proportion of aggregate total figures.
What is the purpose of Vertical Analysis?
Vertical Analysis is used to show how the different components of a company’s financial statements relate to the whole. It enables comparison and better understanding of the relative proportions of account balances, the mix of assets, the sources and uses of cash, and overall profitability.
What are the types of Vertical Analysis?
There are two types of Vertical Analysis: Common Size Balance Sheet (items are a proportion of total assets) and Common Size Income Statement (items are a proportion of sales or revenue).
How is Vertical Analysis calculated?
In Vertical Analysis, each item on the financial statement is expressed as a percentage. Each line item on the balance sheet is calculated as the percentage of total assets and each line item on the income statement is calculated as a percentage of total sales or revenues.
What are the advantages of Vertical Analysis?
Some advantages of Vertical Analysis include: it provides a clear picture of cost structure and profit, it helps in identifying trends over time, it simplifies comparison between companies, and it’s useful for internal management as well as for investment analysis.
What are the disadvantages of Vertical Analysis?
While there are several benefits, there are also some disadvantages. Vertical Analysis only uses data from a single time period, so it doesn’t provide a historical comparison. Also, this analysis assumes percentage relationships are normal, but in reality, they may differ due to changes in policy, market conditions or strategic approach.
Related Entrepreneurship Terms
- Common Size Statements
- Ratio Analysis
- Financial Statement Analysis
- Revenue Percentage Change
- Cost of Goods Sold Percentage
Sources for More Information
- Investopedia – A comprehensive resource for investing education, personal finance, market analysis and free trading simulators
- Finance Formulas – A website that provides clear information on over 200 financial formulas.
- Accounting Tools – A comprehensive site that offers certified courses and hundreds of articles related to the field of accounting.
- Corporate Finance Institute – An institute that offers online certification programs and courses related to finance disciplines.
