Vertical analysis is a technique used to express line items of financial statements in relation to a single item or base. For vertical analysis of income statement, revenue is considered as a base and for balance sheet, total assets is considered as a base.
It’s also referred as vertical common-size analysis of financial statements or common-size vertical analysis of financial statements.
Through Vertical analysis you can know how effectively a company has applied its resources and the proportion in which its distributed among the various balance sheet and income statement accounts for a year.
This type of analysis helps both internal and external users of financial statements to understand the financial performance better. Analysts use common-size vertical analysis to compare the financial statements of one company with another, and across industries. It’s also used to compare and analyze the performance of one period in comparison to another period. For our discussion purpose, we have divided it to two parts:
- Vertical analysis of Income statement
- Vertical analysis of balance sheet
Vertical analysis of the income statement
The main purpose of preparing a income statement is to show company’s profitability for a period/year. It shows how much money the company has generated for the period/year and how much cost it incurred to make money. Growth in revenue indicates company’s success in expanding its market. Comparison to expenses for the same period indicates how the company succeeded in controlling costs. Difference between revenue and expenses reflect company’s profitability. Earnings of a company shows its ability to generate cash flows for dividends and growth.
Investors and lenders are always interested to know the composition of line items of income statement and its growth in proportion to revenue/sales as payment of dividends and interest depends on it.
To perform vertical analysis of the income statement, each line items of the income statement is converted as a percentage of revenue. This means, each line item is divided by revenue to analyze the composition of costs. Therefore, revenue is shown as 100% and every other line item of income statement is shown as a percentage to the total revenue.
If the company has multiple sources, a decomposition of revenue in percentage term is useful to analyze how the underlying business is making money. In case of any unexpected differences, analyst try to find out the real problem to take a decision.
To start analyzing, you need to divide each line item such as cost of goods sold, gross profit, operating expenses, operating income, interest and net earnings by the net sales.
Both operating income percentage and net earnings percentage to total revenue shows the financial success of the company. Operating income percentage to total revenue will show you how the company has managed the day to day affairs. Net profit as a percentage to total revenue shows overall success of the company.
Vertical analysis of income statement
|Revenue product A||40000||40%||42000||42%|
Revenue product B
|Revenue product C||30000||30%||38000||38%|
|Revenue product D||10000||10%||2000||2%|
|Salaries and employees benefits||10000||10%||15000||15%|
|Selling and Administrative Expenses||2000||2%||7000||7%|
|Income Tax Provision||11000||11%||9000||9%|
- EBITDA = earnings before interest tax depreciation and amortization
- EBIT = Earnings before interest and tax
- EBT = Earnings before tax
XYZ company ltd’s income statement
|Cost of goods sold (COGS)||1,65,500||1,48,000||142000|
|Salaries and Wages||1,05,000||97,000||95000|
|Selling and Marketing||35,000||25,000||20000|
XYZ Company’s Vertical Analysis of Income Statement
|Cost of goods sold (COGS)||33%||35%||36%|
|Salaries and Wages||21%||23%||24%|
|Selling and Marketing||7%||6%||5%|
Here is the formula of vertical analysis of income statement, as used in above calculation:
Income statement line item / total sales *100
Common-size vertical analysis of balance sheet
Vertical analysis of balance sheet converts each item to a percentage by the same period’s total assets to know the proportion. This means, each item of a balance sheet is divided by the same period’s total assets to express the resulting figure as a percentage to the total assets.
In balance sheet, vertical analysis is done by showing total assets as 100% and all other line items shown as a percentage of the total assets.
You can use total of liabilities and equity as a base for line items of liability side and total assets as base for line items of asset side of a balance sheet.
Percentage will define the composition of balance sheet. You can compare compositions of one company with another to know which company is at a better position to invest.
For balance sheet, analyst determine percentage component of each major section either to the grand totals of assets or total liabilities plus owner’s equity.
Example of vertical analysis of balance sheet
|Fixed Assets (net of depreciation)||15,000||15%||18,000||18%|
Vertical analysis formula for balance sheet = balance sheet item / total assets * 100
In vertical analysis you take information on the income statement and balance sheet and compare all the numbers in it to a single number in the respective statement.
For income statement, you need to reinstate each line item of income statement as a percentage of sales. Similarly, for balance sheet, each item is expressed as a percentage of total assets. Vertical analysis analyze the relationship of financial line items within a given year.
Various methods are used to interpret financial statements and to help understand the financial position of a company. In addition to vertical analysis, you can uses number of other tools and techniques of fundamental analysis to analyze financial statements. Here is a list of those other tools and techniques:
- Horizontal analysis
- Financial ratios
- Financial projection
- Cash flow budgeting
Ratios are useful when comparisons are made, either between time periods or among different companies. Analyst try to understand the relationships between two or more financial items by using ratio analysis.
In vertical analysis we take sales and total assets of one reporting period or financial statement as a base. Whereas, in horizontal analysis, we either compare company’s specific financial statement of one period with another or cross-sectional analysis of one company with another. Financial statements that include vertical analysis in a separate column are known as common-size financial statements.