Vertical analysis is a method of financial statement analysis in which each line item is listed as a percentage of a base figure within the statement. This technique is beneficial for analyzing financial statements over several periods and comparing the performance and financial health of different companies in the same industry.
Functionality of Vertical Analysis
Calculations
In vertical analysis, the base figure in the income statement is usually total sales or revenue, and in the balance sheet, it is frequently the total assets. Each line item is then expressed as a percentage of its base figure.
Income Statement Example
For instance, if a company has total sales of $1,000,000 and a cost of goods sold (COGS) of $600,000, the COGS would be 60% of the total sales.
Balance Sheet Example
If a company has total assets amounting to $500,000 and inventory worth $100,000, inventory is 20% of total assets.
Importance and Applicability
Vertical analysis simplifies the comparison of financial statements by eliminating the effects of size, thus facilitating comparison of companies of different sizes as well as period-to-period covariances within a company.
Industry Benchmarking
By expressing line items as percentages, financial analysts can easily compare a company’s financial health to industry benchmarks or competitors.
Trend Analysis
This method is also useful for trend analysis over several periods where any percentage variation from one period to another can highlight potential issues or areas of strength.
Types and Special Considerations
Types of Vertical Analysis
- Income Statement Vertical Analysis: Focuses on the income statement and typically uses total sales as the base figure.
- Balance Sheet Vertical Analysis: Applies this method to the balance sheet, usually using total assets as the base.
Special Considerations
Consistency: To ensure the accuracy of vertical analysis, it must be consistently applied over comparable periods.
Inflation and Deflation: Adjustments for inflation or deflation are essential for maintaining the relevancy of the analysis over long periods.
Historical Context
The concept of vertical analysis has been in use since financial statements began gaining importance in business operations and reporting. It provides stakeholders with a more comprehensive understanding of financial proportions within single accounting periods.
Comparisons and Related Terms
Vertical vs. Horizontal Analysis
- Vertical Analysis: Each line item is listed as a percentage of a base figure within the same statement.
- Horizontal Analysis: Compares line items across multiple periods, examining year-to-year changes in data.
Related Terms
- Common Size Analysis: Another name for vertical analysis.
- Ratio Analysis: Uses various financial metrics and ratios to assess a company’s performance and financial health.
FAQs
Q1: How does vertical analysis benefit investors?
A1: It allows investors to quickly assess the proportionate size of various financial statement components, which helps in making comparative judgments about a company’s financial health and operational efficiency.
Q2: Can vertical analysis be used for non-profit organizations?
A2: Yes, vertical analysis can be applied to any financial statements to assess the financial performances, including non-profits.
References
- Financial Accounting Standards Board (FASB)
- International Financial Reporting Standards (IFRS)
- Various textbooks on Financial Statement Analysis by reputable authors
Summary
Vertical analysis provides a framework for analyzing financial statements by expressing each line item as a percentage of a base figure. This method enhances the understanding of a company’s financial structure and comparisons across different periods or companies by eliminating size disparities. It is a fundamental tool for financial analysts, investors, and management for making informed financial decisions.
