What is Vertical Analysis
When financial statement users want to compare line items on different financial statements, they often use horizontal or vertical analysis. Horizontal analysis compares line items of the same category over a period of time. For example, if a company has total liabilities of $5,000 in 2017 and $6,000 in 2018, its total liabilities have increased by $1,000 or 20% over the one-year period. Alternatively, vertical analysis expresses each line item as a percentage of a base figure.
The choice of base figure varies depending on which financial statement is being analyzed. For instance, when analyzing the income statement, the base figure is typically net sales because all other income and expense items are related to sales revenue. On the balance sheet, the base figure is total assets because all other balance sheet items are related to assets. Finally, on the statement of cash flows, the most common base figure is beginning cash plus beginning equivalents because all other cash flow activities increase or decrease that starting point. In short, vertical analysis is a technique that users can employ to better understand the relationships between line items on financial statements.
How to do Vertical Analysis
To do vertical analysis, begin by totaling the revenue for the period you are analyzing. Then, compute the percentage that each line item represents of total revenue. For example, if a company had sales of $100,000 and cost of goods sold of $50,000, then its gross margin would be 50%. You can express this either as a decimal (0.50) or as a percentage (50%).
Once you have calculated the percentages for each line item, you can then compare them side-by-side to see how they have changed over time or how they differ from other companies in the same industry.
Advantages of using Vertical Analysis
There are several advantages of vertical analysis. First, it makes large numbers more manageable and easier to understand. Second, it allows for easy comparison of financial statements from different time periods or different companies. Third, it can reveal trends that may not be immediately apparent when looking at raw data. Finally, vertical analysis is a relatively simple and quick way to perform financial analysis. For these reasons, vertical analysis is an essential tool for any financial analyst.
Disadvantages of using Vertical Analysis
One disadvantage is that it can be difficult to compare companies of different sizes using it. This is because the total dollar amounts on the income statement and balance sheet will be different for each company. As a result, it can be hard to tell if one company is doing better or worse than another.
Another disadvantage of vertical analysis is that it can give a false impression of growth or decline. This is because the percentages can be affected by changes in the denominator (total assets or total revenues). For example, if a company’s total assets increase, its net income will appear to decline as a percentage of total assets even if net income has actually increased. As a result, vertical analysis should be used in conjunction with other financial statement analysis tools to get a complete picture of a company’s financial health.
What information can be gleaned from a Vertical Analysis report
The purpose of this type of analysis is to evaluate different aspects of a company’s financial condition. For instance, a vertical analysis of a company’s balance sheet would show what percentage each asset item is of the total assets. A common use of vertical analysis is to compare a company’s financial statements from one year to another.
This comparison can reveal trends that may not be immediately apparent from the raw data. For example, if it shows that accounts receivable are increasing as a percentage of total assets, this could indicate that the company is having difficulty collecting its bills. Likewise, an increase in inventory as a percentage of total assets could indicate that the company is having difficulty selling its products. By understanding what information can be gleaned from the report, investors and analysts can gain valuable insights into a company’s financial condition.
Why Vertical Analysis is important
It is an important tool that can be used to evaluated financial statements. Also called common-size analysis, vertical analysis expresses each line item on a financial statement as a percentage of a base figure. This makes it possible to compare line items that may not be directly comparable. For example, vertical analysis can be used to compare the gross margin of two different companies. While one company may have a higher gross margin than the other, vertical analysis can help to show whether this is due to different pricing strategies or different cost structures. As a result, vertical analysis is an essential tool for financial analysts and investors.
How to make sure it is done correctly
When performing it, also known as a common-size analysis, it is important to correctly format the data. The first step is to select a base year, which is the year that will be used as the 100% point of comparison. All other years will be expressed as a percentage of the base year. For example, if assets are being analyzed and the base year is 2015, then 2016 assets would be expressed as a percentage of 2015 assets.
The next step is to calculate each financial statement item as a percentage of the appropriate base figure. For instance, sales would be calculated as a percentage of total assets, while income from operations would be calculated as a percentage of sales. Once all the calculations have been made, it is important to properly interpret the results. A good way to do this is to compare the results from one year to another in order to identify trends. For instance, if income from operations has been steadily increasing over time, it could be indicative of improved efficiency. If you take the time to correctly format and interpret your data, a it can be a valuable tool for financial analysis.
