Vertical Analysis: Overview, calculations, examples and primary purpose
The ability to read and interpret financial reports is a prerequisite for many positions in a range of industries. Accountants, financial advisors, bankers, managers, and CEOs, among others, must be able to read and interpret complex financial reports.
Knowing what vertical analysis is and how it may be used in the workplace would help you become ready for a job in this field. As an added bonus, it can help you make sense of the data included in your own financial records.
This article defines vertical analysis, describes its process, and provides many trend assessments of current vertical analysis applications.
What is vertical analysis?
A method used in accounting termed vertical analysis enables a proportional evaluation to be made of documents like financial statements of a corporation.
Financial statement items are reported as percentages of one another to facilitate vertical analysis. This step is taken in order to ensure that the analysis is carried out in the most thorough manner possible.
If, for example, the rationale being utilized on the income statement is revenue, then each piece of data will be expressed as a percentage of the revenue being used.
The net income or the total gross sales can serve as the foundation for a financial report. Including a long-term debt or equity as a proportion of total assets ratio on the income accounts is one possible way to do this.
Displaying each part of the budget as a percentage of a significant number makes it easy for experts to detect linkages. Also, it's far less of a hassle to evaluate similar businesses.
This approach is helpful since it quickly and clearly breaks down the financial statements' graphs and charts of various account balances as a proportion of the whole.
By comparing a large number of firms at once, analysts can ensure that indicators like net income and total income are comparable among businesses of varied sizes.
This exemplifies how various companies handle their assets, liabilities, revenues, expenses, and cash flow.
Vertical analysis vs horizontal analysis
Changes throughout time are the primary emphasis of vertical analysis, whereas percentage changes between two time periods are shown visually in horizontal analysis.
Different from horizontal analysis formulas, which determine the extent to which something has changed through time, vertical analysis formulas take into account the relative importance of each component to the whole.
However, note that vertical analysis can still be used to compare line items' percentage changes from one quarter or year to the next.
Specifically, percentages from a vertical analysis may not always correspond to percentages of change.
Vertical analysis examples
The term vertical analysis came about when a downward straight analysis was done by looking for information in common-sized financial documents.
Most of the time, executives use vertical analysis to find changes or differences in important parts of financial statements, such as individual balance sheets or groupings of assets.
Benchmarking and vertical analysis are two applications of the same core idea. The company's management decides on an initial sum to use as a basis or benchmark for measuring the company's overall level of performance.
The base amount is often determined by aggregating the results of the financial statements for the same year. After that, the procedure for calculating the common-size fraction may be applied to the monetary item.
Using this ratio, executives can evaluate how different departments are faring financially. Similar to ratio analysis, vertical analysis compares start-ups' financial data to that of large businesses.
The common size Fraction is also useful for comparing businesses that operate in the same industry but use different currencies or those that operate in a completely different industry.
Here is an example of vertical analysis and how it functions. Let's imagine that Company Y has a cost of products sold of $100,000 while having a gross sales amount of $700,000.
They incur $300,000 in General expenses at a 25% tax rate. If they adopted vertical analysis to compile their statements, the revenue report would look like this:
How is it calculated?
Vertical analysis uses a simple percentage formula for computation:
The vertical analysis formula is simply dividing each individual figure by your base amount, then multiplying the result by 100.
You'll need to choose a point of reference before you can input that number into the equation for vertical analysis.
Checking a company's balance sheet, you'll likely see the entire assets or liabilities listed as the initial amount.
How this is done is conditional on the variable under examination. The various accounting records will use a broad range of suitable starting amounts.
What is the primary purpose of vertical analysis?
By doing a vertical analysis, you can learn more about your business's financial status and make more informed decisions about the company's future.
If you know your base number, you have something to compare everything else to it, and if you compare each budget item to the base number, you can see where your approach could be weak or strong.
Vertical analysis might be used in tandem with horizontal analysis to help spot patterns and maximize profits using data-driven strategies.
Other purposes and benefits of using Vertical Analysis include:
- As a result of the fact that one may express the relationship between certain items on financial statements and the bottom line as a percentage, vertical analysis is an excellent technique that can be used to simplify the analysis.
The management team of a company could use the percentages to set goals and define threshold restrictions using these numbers.
In the event that, for example, the profit per unit falls below a specified threshold percentage, management may consider suspending operations at that particular unit.
- Vertical analysis is a more powerful technique than horizontal analysis since it illustrates how the revenues of a certain account have changed in unison with one another over time.
- In addition to this, vertical analysis is useful when comparing the company's financial records to the normal trends that are seen in the industry.
If one were to conduct a study of whole industries while utilizing actual monetary values as a measuring stick, the analysis would be inefficient.
The solution to this problem is to use percentages based on standard sizes, which also makes it simpler to compare different types of businesses.
- It is also extremely useful when comparing two or more firms that are working in the same sector but are of various sizes.
When compared to one another, the balance sheets of companies with values of one billion and half a million dollars might be difficult to interpret.
By using vertical analysis, auditors can agree on a standard set of size metrics that let them compare and contrast numbers with very different values quickly and easily.
Vertical analysis makes it much easier to compare and contrast the financial statements of different companies.
Additionally, in all sectors of the economy, vertical analysis may help you understand how the relative percentages relate to the numbers and to one another.
When comparing different financial accounts, vertical analysis is a useful tool and a well-known strategy to use. In addition to the financial success of businesses, when combined with horizontal analysis, vertical analysis allows for the generation of a comprehensive picture of the financial status of an organization.