Vertical Analysis is a method of financial statement analysis in which each line item on a financial statement is expressed as a percentage of a base figure within that statement. This technique allows for easier comparison across different periods, companies, or industries by standardizing the financial data. Vertical analysis is commonly applied to the income statement and balance sheet to assess the relative size of various components, such as revenue, expenses, and assets.
Key Aspects of Vertical Analysis
Income Statement Vertical Analysis
On the income statement, vertical analysis involves expressing each item as a percentage of total revenue (or sales). This allows for analysis of the cost structure, profitability, and expense management of a company. For example:
| Item | Amount (in thousands) | Percentage of Total Revenue |
|---|---|---|
| Total Revenue | $1,000 | 100% |
| Cost of Goods Sold | $600 | 60% |
| Gross Profit | $400 | 40% |
| Operating Expenses | $200 | 20% |
| Net Income | $100 | 10% |
In this example, vertical analysis shows that 60% of revenue goes to the cost of goods sold, 20% to operating expenses, and the company retains 10% as net income.
Balance Sheet Vertical Analysis
On the balance sheet, vertical analysis involves expressing each item as a percentage of total assets. This provides insight into the company’s asset structure, funding sources, and financial leverage. For example:
| Item | Amount (in thousands) | Percentage of Total Assets |
|---|---|---|
| Total Assets | $2,000 | 100% |
| Current Assets | $800 | 40% |
| Fixed Assets | $1,200 | 60% |
| Liabilities | $1,200 | 60% |
| Equity | $800 | 40% |
Here, vertical analysis shows that 60% of the company’s assets are financed through liabilities, and 40% through equity, with current assets making up 40% of total assets.
Purpose and Benefits of Vertical Analysis
- Comparability: Vertical analysis standardizes financial statements, making it easier to compare different companies or the same company across different periods, regardless of size or currency differences.
- Trend Analysis: By analyzing financial statements over multiple periods using vertical analysis, trends in how revenue is allocated to various expenses or changes in the asset structure can be identified.
- Benchmarking: Companies can use vertical analysis to compare their financial ratios and percentages to industry benchmarks or competitors, helping them assess their relative performance.
Applications of Vertical Analysis
- Internal Analysis: Managers and analysts use vertical analysis to monitor performance, make budgeting decisions, and assess areas for improvement.
- External Analysis: Investors, creditors, and analysts use vertical analysis to evaluate a company’s financial health, efficiency, and profitability, aiding in investment and lending decisions.
Example of Using Vertical Analysis
Suppose a company’s income statement shows the following:
- Total Revenue: $1,000,000
- Cost of Goods Sold (COGS): $600,000
- Gross Profit: $400,000
- Operating Expenses: $200,000
- Net Income: $100,000
Applying vertical analysis:
| Item | Amount | Percentage of Total Revenue |
|---|---|---|
| Total Revenue | $1,000,000 | 100% |
| Cost of Goods Sold | $600,000 | 60% |
| Gross Profit | $400,000 | 40% |
| Operating Expenses | $200,000 | 20% |
| Net Income | $100,000 | 10% |
This analysis shows that for every dollar of revenue, 60 cents are spent on COGS, 20 cents on operating expenses, and 10 cents are retained as profit.
Conclusion
Vertical analysis is a financial statement analysis tool that expresses each line item as a percentage of a base figure, such as total revenue on the income statement or total assets on the balance sheet. It allows for easier comparison across time periods, companies, or industries, helping users assess a company’s financial structure, profitability, and efficiency.
