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 marginGross Profit MarginGross Profit Margin is the ratio that calculates the profitability of the company after deducting the direct cost of goods sold from the revenue and is expressed as a percentage of sales. It doesn’t include any other expenses into account except the cost of goods sold.read more 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 dropped significantly in 2015 to 17.4%.
- The corresponding net income has also decreased to 8.6% in 2015.
- Effective tax ratesEffective Tax RatesEffective tax rate determines the average taxation rate for a corporation or an individual. For both, there is a similar formula only with variation in considering variables. The effective tax rate formula for corporation = Total tax expense / EBTread more 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:
| Year 1 | Year 2 | Year 3 | |
|---|---|---|---|
| Sales | $3,50,000 | $4,25,000 | $5,00,000 |
| Cost of Goods Sold | $1,00,000 | $1,35,000 | $1,70,000 |
| Gross Profit | $2,50,000 | $2,90,000 | $3,30,000 |
| Salaries | $95,000 | $98,000 | $1,00,000 |
| Rent and Utilities | $30,000 | $35,000 | $40,000 |
| Marketing | $20,000 | $25,000 | $30,000 |
| Other Expenses | $10,000 | $12,000 | $15,000 |
| Total Expenses | $1,55,000 | $1,70,000 | $1,85,000 |
| Net Income | $95,000 | $1,20,000 | $1,45,000 |
If we divide each line item for the year with the sales for that year, the common size analysis of the income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more of the Company will look like:
| Year 1 | Year 2 | Year 3 | |
|---|---|---|---|
| Sales | 100% | 100% | 100% |
| Cost of Goods Sold | 29% | 32% | 34% |
| Gross Profit | 71% | 68% | 66% |
| Salaries | 27% | 23% | 20% |
| Rent and Utilities | 9% | 8% | 8% |
| Marketing | 6% | 6% | 6% |
| Other Expenses | 3% | 3% | 3% |
| Total Expenses | 44% | 40% | 37% |
| Net Income | 27% | 28% | 29% |
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.
- The salaries of the employees have decreased over the years.
- Rent and utilities, marketing, 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.read more 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 statementCommon Size Analysis Of Income StatementCommon Size Income Statement is a Company’s financial statement that presents every listed line item as a percentage of total revenue or sales. Moreover, it helps analyze the contribution of every item towards the profitability of the Company. read more, it will look like the following:
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For eg:
Source: Vertical Analysis of Income Statement (wallstreetmojo.com)
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 profitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services.read more, 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 Analyzing 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 expenseAmortization ExpenseAmortization of Intangible Assets refers to the method by which the cost of the company's various intangible assets (such as trademarks, goodwill, and patents) is expensed over a specific time period. This time frame is typically the expected life of the asset.read more.
Limitations
- No standard ratios: Since all the line items are divided by the common sales number, there is no standard financial ratioStandard Financial RatioFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on.read more (except for profit margins) in the vertical analysis of the income statement. Hence, it may not be easy to make 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 usedAccounting Principles UsedAccounting principles are the set guidelines and rules issued by accounting standards like GAAP and IFRS for the companies to follow while recording and presenting the financial information in the books of accounts.read more 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 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. read more; thus, the numbers may not be comparable from one period to another.
- Window dressing: Window dressingWindow DressingWindow dressing in accounting refers to the intentional manipulation of financial statements by company management in order to present a more favourable picture of the company to users of the financial statement before it is released to the public.read more 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 the case of an income statement, it is revenue/net sales.
The 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 the 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.
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