You can then get a summary of how the business is operating and performing over time. Vertical analysis provides insights into the composition of your financial statements and their relationship with the base amount. Also known as the vertical percentage analysis, you can then use this to evaluate company performance and compare it with previous results to understand the direction of your company.
Overall financial performance is usually analyzed with horizontal or ratio comparison tools. As noted before, we can see that salaries increased to 22% as a percentage of total sales in Year 3, compared to 20% in year 2. We can also view from this table that marketing expenses as a percentage of total sales increased to 8% as a percentage of total sales in year 3, compared to 6% in year 2. However, these two types of expenses did not really rise substantially and only account for a relatively small proportion of revenue. Multiple year financial statements can be compared and comparative analysis of such statements can be carried out to enhance the effectiveness of vertical analysis. Such analysis provides us with comparable percentages that can be used for comparison of financial statements with the previous years.
Whether you’re considering cost-cutting measures, pricing strategies, or investment decisions, vertical analysis helps evaluate the potential impact on key line items. Vertical analysis does not consider external factors and may not provide a complete picture of a company’s financial health. This allows analyzing the composition of the income statement and understand the relative significance of each item in relation to the company’s revenue.
Vertical Analysis: What It Is and How It Can Help You Understand Your Financial Position
When used together, they offer a comprehensive view of the company’s financial health. Vertical analysis (also known as common-size analysis) is a financial statement analysis technique that shows each line item on a financial statement as a percentage. Let’s look at vertical analysis in more detail, explore how it works and examine the differences between vertical analysis and horizontal analysis. In addition, vertical analysis can aid in financial forecasting by projecting future trends based on historical data.
Vertical analysis is exceptionally useful while charting a regression analysis or a ratio trend analysis. It enables the accountant to see relative changes in company accounts over a given period of time. Vertical analysis is most commonly used within a financial statement for a single reporting period, e.g., quarterly. It is done so that accountants can ascertain the relative proportions of the balances of each account. For instance, we can observe that the cost of goods sold represents 40% of net sales, indicating that the production or procurement of goods consumes 40% of the revenue.
Importance of Vertical Analysis in Financial Reporting
To perform such analysis, one needs to create a common size financial statement (for example, a common size income statement). Vertical analysis makes it much easier to read and compare the financial statements of one business to another. This is because you can see the relative percentages in relation to the numbers as well as each other.
- By being able to measure which cost areas of the business are rising (falling) as a proportion of sales, one can then look at the contributing factors in more detail.
- This is in order to get a clear picture of whether your performance metrics are improving or declining.
- This allows analyzing the composition of the income statement and understand the relative significance of each item in relation to the company’s revenue.
How to Perform a Vertical Analysis on Your Balance Sheet
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 vertical analysis is also known as 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.
Vertical financial statement analysis is particularly useful when comparing companies within the same industry. By applying vertical analysis to the financial statements of competitors, analysts can identify differences in cost structures, profitability, and efficiency. This information helps investors and decision-makers make informed choices based on the relative financial health of different companies. When performing vertical analysis, analysts typically examine each of the core financial statement components independently. It is not usual, for instance, to assess line items on the income statement as a percentage of gross income. Nevertheless, there are situations where it does make sense to cross-reference ratios of specific accounts, such as expressing liabilities as a percentage of net income.
One of the benefits of using common size analysis is that it allows investors to identify large changes in a company’s financial statements. It mainly applies when the financials are compared over a period of two or three years. Any significant movements in the financials across several years can help investors decide whether to invest in the company.
Vertical analysis makes it much easier to compare the financial statements of one company with another and across industries. By using vertical analysis we can look at the proportional contribution of each cost (COGS, marketing, salaries, etc) and analyze which are having a significant impact on profitability. It is a simple and consistent method that can be used year on year and also compare different companies. By being able to measure which cost areas of the business are rising (falling) as a proportion of sales, one can then look at the contributing factors in more detail. Vertical analysis enables the analyst to delve deeper into a financial statement and better comprehend its composition.