Vertical analysis, an accounting technique, facilitates the proportional examination of various documents, such as financial statements. When doing vertical analysis, each line item within a financial statement was expressed as a percentage relative to another item. This includes assessing financial statements. Also, each line item on the statement is presented as a percentage relative to another line item. This analytical approach is usually merged with “horizontal analysis.”
When is Vertical Analysis Used
Vertical analysis, is a form of ratio analysis. It represents each line within financial statements as a proportion relative to another specified item. With this, it initiates a consistent standard for comparison. If the chosen base in an income statement is revenue, each line item is shown as a percentage of the revenue figure. Alternatively, the base can be net income or total gross income in the case of an income statement. It can also pertain to total assets, liabilities, or equity on a balance sheet.
This approach aids the swift identification of correlations by showing the proportion of various account balances in the financial statements. Furthermore, vertical analysis streamlines the comparison of different companies operating within the same industry. This is done by portraying financial data in the form of percentages rather than absolute values. This makes it possible to assess companies with varying levels of sales or assets on a level playing field. Consequently, analysts can normalize items such as total income and net income across businesses of varying sizes. This reveals how these enterprises manage their assets, liabilities, income, expenses, and cash flow, despite of their overall scale.
Importance of Vertical Analysis
Vertical analysis is useful to stakeholders. This helps in understanding the proportions and performance of various accounts related to one another. It provides businesses with a more complex perspective of their financial well-being. It’s also important to assess the ratio of specific accounts over different time periods. With this, organizations can monitor changes and lead them to strategic decision-making. Additionally, vertical analysis can serve as a tool for comparing a company’s performance to industry standards.
Vertical Analysis vs. Horizontal Analysis
Analysts often require a longitudinal assessment of a business’s performance, known as horizontal analysis or trend analysis. Horizontal analysis changes over time in various financial statement elements, such as revenue and expenses. However, vertical analysis shows each financial statement item as a percentage of its earlier period value.
This approach aids in evaluating a company’s ability to increase revenue. At the same time, it helps with managing expenses and assessing the efficiency of assets, liabilities, and cash source utilization. For instance, it might involve comparing variable expenses over three years. Expressing year 2 and 3 expenses as percentages of year 1. If year 1, 2, and 3 variable expenses were $150, $148, and $145, the ratios for years 1, 2, and 3 to year one would be 100%, 99%, and 97%. This indicates a declining trend in variable expenses over three years.
However, relying solely on horizontal analysis presents each item in isolation. This emphasizes the importance of combining both horizontal and vertical analyses. By doing so, one gains a comprehensive view of how line items compare to themselves over time and whether these changes align with the current time period’s context.
Vertical analysis, also known as common-size analysis, and horizontal analysis, or trend analysis, are fundamental tools in financial statement analysis. Vertical analysis assesses the relative representation of each financial statement line item by expressing them as percentages of total sales. Meanwhile, horizontal analysis examines changes over time in financial elements, aiding in identifying performance trends. Employing both vertical and horizontal analyses provides a holistic understanding of a business’s financial position and performance.
How to Apply Vertical Analysis
When performing vertical analysis, analysts typically examine each of the core financial statement components independently. This is usually done without directly comparing them to one another. 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.
In the process of preparing vertical analysis, it is usual to present these ratios in a column located to the right of the financial statement values. Vertical analysis is usually shown as follows:
The column that displays the ratio of each line item to gross sales sits to the right of the actual values. While financial statements are occasionally shown in this manner, FP&A analysts often customize their approach based on the specific information they aim to understand. Although people assess each financial statement uniquely and compare ratios using various methods, they usually encounter this presentation methodology.
Pros and Cons of Vertical Analysis
Pros:
- Facilitating direct comparisons of the relative sizes of different financial statement line items across all reporting periods.
- Enabling the detection of significant trends, whether related to sales growth, contraction, or other critical elements.
- Uncovering potential underlying issues, such as cost increases not aligned with revenue growth.
- Streamlining the rapid and precise comparison of various organizational segments, as each segment’s expenses are expressed as a percentage of the total sales for the entire organization.
- Assisting in the identification of superior-performing segments, thereby aiding managers in their decision-making processes.
Cons:
- It lacks the capability to offer insights into the absolute magnitude of different line items, potentially leading to misleading comparisons between companies of varying sizes.
- Vertical analysis does not consider external factors, including inflation, that can influence year-on-year fluctuations in figures.
- This method falls short in providing a comprehensive assessment of a company’s overall performance, as it solely examines individual components and their relative proportions within the financial statement.
- Transactions with related entities, such as subsidiaries, are usually omitted from calculations due to the intricate nature of accounting processes.
Conclusion
Vertical analysis emerges as a valuable accounting technique that offers a proportional examination of financial statements, facilitating comparisons and trend identification. It allows stakeholders to gain a deeper understanding of a company’s financial health by showing each line item as a percentage of another specified item, making it easier to assess performance across different time periods and industries. Its advantages lie in its ability to highlight trends, identify potential issues, and streamline segment comparisons. However, it is important to recognize that vertical analysis has limitations, including its inability to provide absolute values and the absence of consideration for external factors. To obtain a clear overview, businesses often combine both vertical and horizontal analyses, thus ensuring a holistic understanding of financial position and performance. Ultimately, these tools remain crucial for making informed financial decisions and evaluating a company’s standing in the competitive landscape.
