Vertical Analysis of Income Statement (Example, Interpretation, Limitation)

What is Vertical Analysis of Income Statement?

Vertical Analysis refers to the analysis of the Income Statement where all the line item which are present in company’s income statement are listed as a percentage of the sales within such statement and thus helps in analyzing the company’s performance by highlighting that whether it is showing upward or downward trend.

Vertical Analysis of Colgate’s Income Statement

Let us see the example of a vertical analysis of Colgate’s Income Statement. In the below snapshot, we have divided each income statement line item with Net Sales for the period between 2007 to 2015.

Interpretation

The cost of Sales has been in the range of 41%-44% historically. This implies that Colgate’s gross profit margin has been around 56% to 59%.
There has been a decreasing trend in Selling General and administrative expenses from 36.1% in 2007 to 34.1% in the year ending 2015.
We also note that Operating income has dropped significantly in 2015 to 17.4%.
The corresponding net income has also decreased to 8.6% in 2015.
Effective tax rates jumped to 44% in 2015.

Examples of Vertical Analysis of Income Statement

Let’s see some examples of vertical analysis of an income statement to understand it better.

Example #1

Consider the following example of an income statement of the XYZ Company:

If divide each line item for the year with the sales for that year, the common size analysis of the income statement of the Company will look like:

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Interpretation

By converting each number by the sales number for the year, the comparison between the line items over the years is easy.

The Gross Profit of the Company grew in dollar terms but the gross profit % dropped over the years. This shows that the cost of the raw materials and goods has increased and is not in line with the increase in sales
Salaries of the employees have decreased over the years
Rent and utilities, marketing and other expenses have remained more or less constant as a percentage of the sales
The net income has increased by about 1% every year

Example #2

Let us look at another example, the income statement of Apple Inc.

Source: Apple SEC filings

If we convert the above into common size analysis of income statement, it will look like the following:

Vertical Analysis of Income Statement Interpretation

All the numbers are more or less the same with a difference in the range of 1%-2% over the years
The net income of the Company has increased from 2016 to 2018 by 1.5%
The Companies expense on research and development has increased by nearly 1% as a percentage of net sales

Advantages

Easy to Understand and Interpret: Vertical analysis of income statement is easy to understand and interpret. The analyst after converting the numbers on each line item into a percentage of sales can compare them and analyze the performance of the Company better.
Time Series Analysis: It helps in doing a time series analysis of the various line items like the expenses, employee salary, gross profit, operating profit, and net profit.
Analysis can be done looking at the common size sheet at one go. Since all the numbers are available as a percentage of the sales, the analysts can easily analyze the details of the Company’s performance.
Help in Analysing Structural Composition: A common size analysis of income statement helps in analyzing and ascertaining changes to any structural components of the income statement i.e. the salary expense, marketing expense, or depreciation and amortization expense.

Limitations

No standard ratios: Since all the line items are divided by the common sales number, there is no standard financial ratio (except for profit margins) in the vertical analysis of income statement. Hence, it may not be easy to take any decision based on such analysis and looking at the change in the percentage of various components of the income statement.
Change in price-level/inflation: Vertical analysis of income statement does not take into account the change in the price level or inflation effects. Sales numbers may be inflated every year due to inflation but this is not taken into account as the numbers are not adjusted for inflation cost.
Accounting principle consistency: If the accounting principles used are not the same year on year then the vertical analysis of income statement is useless till it is adjusted for the changes and made comparable year on year.
Seasonal fluctuation: If the Company is involved in the sales of the items which are seasonal in nature then the vertical analysis may not be helpful. The seasonal fluctuations cause variation in sales, cost of goods sold thus the numbers may not be comparable from one period to another.
Window dressing: Window dressing or using accounting principles in favor of the Company cannot be recognized easily in the vertical analysis of the income statement. Such effects render the analysis useless.
Qualitative analysis: It provides only quantitative analysis and does not consider qualitative measures taken by the Company like new marketing techniques etc.

Conclusion

Vertical Analysis of the income statement shows the revenue or sales number as 100% and all other line items as a percentage of sales. All the line items in a vertical analysis are compared with another line item on the same statement, in case of an income statement, it is revenue/net sales.

A common size or vertical analysis of income statement is the statement where each line item is expressed as a percentage of sales. The comparison of each number becomes easier when compared as a percentage of sales/revenue. While such an analysis is helpful for the analysts to compare the performance of the Company over years or two Companies in the same sector and line of business but it has its own limitations. Thus, the analysis should take into account the limitations of the vertical analysis of the income statement while comparing and inferring the results.