Definition
Vertical Analysis of an Income Statement is a method of financial statement analysis in which each line item is listed as a percentage of a base figure within the statement. This technique is primarily used to review the relative proportions of different line items in an income statement, such as the proportion of cost of goods sold to total revenue. It helps to understand the correlation and trends of various expense heads with respect to the revenue.
Key Takeaways
- Vertical Analysis of Income Statement, also known as common size analysis, is a technique in financial statement analysis where each line item is listed as a percentage of a base figure within the statement. In an income statement, this base is generally the Total Revenues, making it easy to see the relative proportions of each category and sub-categories.
- This method allows for easy internal and external comparison over time as changes remain visible. Thus, Vertical Analysis assists in determining trends and performance and can be a useful tool for comparing similar companies in an industry or comparing different periods of time for the same company.
- Vertical Analysis is a valuable tool because it reduces the impact of the size difference of businesses, enabling comparative evaluation of their performance. It doesn’t provide dollar amounts of revenues, costs, or profits, but it gives a clear picture of the allocation and utilization of resources.
Importance
Vertical Analysis of an Income Statement is important because it provides a way to evaluate a company’s financial performance over a certain period.
It involves converting each line item on the company’s income statement (like costs, revenues, and profits) into a percentage of revenue.
This method allows for easy comparison and understanding of the company’s cost structure and areas of expense.
It’s particularly helpful in measuring a company’s efficiency and profitability, highlighting trends in revenues and expenses and how each item impacts the company’s profitability.
Additionally, it aids in comparing businesses of different sizes within the same industry by providing a relative proportion, rather than absolute figures.
Explanation
Vertical Analysis of an Income Statement, also referred to as common-size analysis, serves a critical purpose in financial analysis by allowing for a company’s financial statement’s line items to be viewed in proportion to a selected base figure, which is usually the total sales or total revenues. This type of analysis aims to highlight the relationship between individual components, such as operating expenses or the cost of goods sold, and total sales or revenue during a particular period.
It allows for an in-depth view of the company’s financial health and may reveal hidden trends or correlations that might be missed in a typical numeric review. This kind of analysis is widely used by stakeholders such as investors, creditors, and financial analysts to evaluate the financial performance and condition of the company.
They examine the percentage change in line items year on year to detect any troubling trends or unsuitable cost structures. For example, if the costs of goods sold showed a consistent upward trend relative to the total sales, it might suggest deteriorating operational efficiency.
As such, Vertical Analysis of Income Statement is a valuable tool for comparing the performance and efficiency of diverse companies, irrespective of their size.
Examples of Vertical Analysis of Income Statement
Apple Inc.: In Apple’s 2020 Annual Report, a vertical analysis would show the cost of sales, R&D expenses, or selling, general and administrative expenses as a percentage of total revenue. This would give stakeholders an understanding of how much of the total revenue is being used for these specific expenses and may help identify any trends over time.
Walmart Inc.: Walmart is a retail giant with diverse operations across the globe. A vertical analysis of its income statement can show the proportion of revenue that goes into cost of goods sold, operational expenses, and other overheads. This analysis can also reveal how much of the total revenue is transformed into net income, thus providing insights into the company’s profitability.
Tesla Inc.: For a rapidly growing company like Tesla, it’s important for potential investors and stakeholders to know how efficiently it’s running its operations. A vertical analysis of Tesla’s income statement can help decipher what percentage of total revenue goes into R&D, what portion is spent on selling and administrative expenses, and how these figures change year-on-year. This analysis can shed light on Tesla’s operational efficiency and profitability trends.
FAQs about Vertical Analysis of Income Statement
What is Vertical Analysis of Income Statement?
Vertical Analysis of an income statement is a method by which each item in the income statement is shown as a percentage of a particular base item. For example, each item might be expressed as a percentage of sales.
Why is Vertical Analysis of Income Statement important?
Vertical Analysis provides a simple yet powerful tool for understanding the proportion of different components in an income statement and how they relate to revenue. It can reveal trends and anomalies, helping investors, management, and other stakeholders make informed decisions.
How is Vertical Analysis of Income Statement performed?
Vertical analysis is typically performed by dividing each item on the income statement by the gross sales for that period, then multiplying the result by 100 to express it as a percentage.
What is the main benefit of performing a Vertical Analysis of an Income Statement?
The main benefit of vertical analysis is that it allows for easy comparisons. Whether you want to compare your company with another, or compare your company’s current performance with its past, vertical analysis can provide clear, meaningful insights.
Does Vertical Analysis apply to all statements?
No, vertical analysis is most commonly used in income statements, however it can be useful in other statements such as balance sheets. The main idea is to express line items as a percentage of a base, which can provide insightful percentages regardless of the statement.
Related Entrepreneurship Terms
- Common-Size Income Statement
- Percentage of Sales Method
- Financial Statement Analysis
- Income Statement Items
- Comparative Financial Statements
Sources for More Information
- Investopedia: An extensive resource for defined terms, example analyses, and tutorials about financial terms including Vertical Analysis of Income Statement.
- Accounting Tools: Provides resources and articles that cover various topics in accounting and finance, including Vertical Analysis.
- Corporate Finance Institute: Offers detailed and comprehensive guides and educational resources on a variety of finance topics, including Vertical Analysis.
- My Accounting Course: It’s a blended learning website that covers almost all areas of accounting and finance, which would help understand Vertical Analysis of Income Statement in depth.
