What is Vertical Analysis Formula?
Vertical analysis is a kind of financial statement analysis wherein each item in the financial statement is shown in the percentage of the base figure. It is one of the popular methods of financial statements as it is simple and also called a common size analysis. Here, all the income statement items are stated as a percentage of gross sales.
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 analysisHorizontal AnalysisHorizontal analysis interprets the change in financial statements over two or more accounting periods based on the historical data. It denotes the percentage change in the same line item of the next accounting period compared to the value of the baseline accounting period. always looks at the amount from the financial statement over the horizon of many years. The significance of vertical analysis accounting is well-established in businesses irrespective of their size or stature.
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Vertical Analysis Explained
Vertical analysis, often referred to as common-size analysis, is a crucial financial tool used in the world of business and finance to assess the relative proportions of different financial statement items.
This method expresses each line item on a financial statement as a percentage of a key benchmark, typically total revenue (in the case of the income statement) or total assets (for the balance sheet). It allows stakeholders, including investors, analysts, and management, to gain valuable insights into a company’s financial structure and performance.
In the realm of finance, vertical analysis aids in comparing the composition of income and expenses over time or against industry peers. 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.
For instance, a vertical analysis of an income statement might reveal that a company is spending a higher percentage of its revenue on marketing expenses compared to its competitors. This could prompt management to reevaluate their marketing strategy or cost structure to enhance profitability.
Therefore, a vertical analysis equation is an indispensable tool in the world of finance and business, enabling stakeholders to gauge a company’s financial health, efficiency, and allocation of resources by expressing financial data as percentages relative to a chosen benchmark. This technique fosters informed decision-making and strategic planning, vital for sustained success in today’s competitive financial landscape.
In the vertical analysis accounting of financial statements, the percentage is calculated by using the below formula:
Vertical Analysis formula = Individual Item / Base Amount *100
The vertical analysis formula for the Income Statement and Balance Sheet are given below –
Vertical Analysis Formula (Income Statement) = Income Statement Item / Total Sales * 100
Vertical Analysis Formula (Balance Sheet) = Balance Sheet Item / Total Assets (Liabilities) * 100
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.
Vertical Analysis Formula Explained in Video
Example of Vertical Analysis Formula
Example of the vertical analysis accounting of the financial statement, which shows the total amount and percentage.
The total sales are $1000000, and the cost of goods soldCost Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. is $400000. In addition, the salary paid to the workers of the company is $300000, office rent paid is $30000, utilities worth $40000 and other expensesExpensesOther expenses comprise all the non-operating costs incurred for the supporting business operations. Such payments like rent, insurance and taxes have no direct connection with the mainstream business activities. are $60000.
Vertical Analysis Formula = Individual Item / Total Sales * 100
The above vertical analysis example shows the company’s net profit where we can see the net profit in both amount and percentage. Where the same report can be used to compare with other industries. The income statement can be compared with previous years, and the net income can be compared where it helps to compare and understand the percentage of rising or loss of income.
The below vertical analysis example helps to understand the comparison.
In the above vertical analysis example, we can see that the income decreases from 1st year to 2nd year, and the income increases to 18% in the 3rd year. So by using this method, it is easy to understand the net profit as it is easy to compare between the years. We can easily understand that the total expenses gradually increased from 43% to 52%, and the net income get reduced from 1st year to 2nd year. In the 3rd year, the COGS decreased compared to the previous years, and the income increased.
Let us now calculate the Vertical Analysis of the Balance Sheet with the help of another example.
Vertical Analysis Formula = Individual Item / Total Assets (Liabilities) * 100
The information provided in the balance sheet provides the change in working capitalChange In Working CapitalThe change in net working capital of a firm from one accounting period to the next is referred to as the change in net working capital. It is calculated to ensure that the firm maintains sufficient working capital in each accounting period so that there is no shortage of funds or that funds do not sit idle in the future., fixed income over some time. Where the altered business requires a different amount on the ongoing fund. The same can be done with the income statement, where the previous years can be compared and find out the change in the working capital and fixed assetsFixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples. over time.
Let us understand the advantages of vertical analysis equation through the points below.
- It is one of the easiest methods of financial analysis.
- Vertical analysis of financial statements provides a comparable percentage that can be compared with the previous years.
- Different organization statements can be compared as the comparison is made in percentage.
- Vertical analysis is also instrumental in comparing the financial statementsThe Financial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. with the previous year’s statement and analyzing the period’s profit or loss.
- Where it helps to understand the percentage/share of the individual items;
- Where it helps to understand the structural composition of the various components like cost, expenses, assets, and liabilities.
Despite the various advantages, there are a few factors of vertical analysis accounting that prove to be a disadvantage. Let us understand them through the explanation below.
- The vertical analysis of financial statements does not help make a firm decision as there is no standard percentage or ratio regarding the change in the income statement components or the balance sheet.
- The accounting conventions are not followed vigilantly in the vertical analysis.
- The liquidity of the organizationLiquidity Of The OrganizationLiquidity is the ease of converting assets or securities into cash. cannot be measured precisely by using the analysis.
- Quality analysis is not done by using vertical analysis of financial statements as there is no consistency in the ratio of the elements.
Vertical Analysis Vs Horizontal Analysis
Both techniques provide valuable insights for financial analysis and decision-making, but they serve different purposes and offer distinct perspectives on a company’s financial performance. Let us understand the differences through the comparison below.
- Vertical analysis, also known as common-size analysis, involves expressing each line item on a financial statement as a percentage of a specific benchmark, typically total revenue (for income statements) or total assets (for balance sheets).
- Vertical analysis accounting helps stakeholders assess the relative proportion of different financial statement items within a single period, making it easier to identify trends, patterns, and areas of concern.
- It’s valuable for comparing the composition of income and expenses within a specific period or against industry peers, enabling insights into a company’s financial structure and performance.
- For example, if a company’s vertical analysis of the income statement reveals that 30% of its revenue is spent on marketing, it means marketing expenses make up 30% of the total revenue.
- Horizontal analysis, also known as trend analysis, involves comparing financial data across multiple periods to identify changes or trends over time.
- Horizontal analysis helps stakeholders understand how a company’s financial performance evolves over several periods. It reveals whether specific line items are increasing or decreasing and by what percentage.
- It’s beneficial for spotting growth or decline in revenue, expenses, and other financial metrics, aiding in forecasting and strategic decision-making.
- For example, if a company’s horizontal analysis of the income statement shows that net profit has grown by 10% annually over the last five years, it indicates a positive trend in profitability.
Guide to what is Vertical Analysis. Here we explain its formula, examples, advantages, disadvantages, and compare it with horizontal analysis. You may learn more about financial statement analysis from the following articles –