Vertical analysis is the comparison of financial statements by representing each line item on the statement as a percentage of the total amount.
It’s a technique used in financial statement analysis and is often combined with horizontal analysis.
In this FAQ we will discuss what vertical analysis is, how it relates to horizontal analysis, and provide a simple example of how to apply it.
What Is Vertical Analysis?
Vertical analysis is a type of ratio analysis that presents each line on the financial statements as a percentage of another item. It uses a fixed point of reference that is used to compare.
For example, on the income statement if the base chosen is revenue, then each line item would be shown as a percentage of revenue. The base may also be net income, total gross income, or any other detail of income that you would want to compare.
On a balance sheet this might mean showing the percentage of accounts receivable in comparison to the total assets as shown in the example below.
Why is Vertical Analysis Important?
By showing each line item as a percentage of an important total this allows FP&A analysts to quickly identify correlations, while at the same time making it easier to compare various companies across the same sector.
That is because this approach quickly reveals the proportion of various account balances reflected in the financial statements.
When analysts compare various companies at the same time it allows them to normalize items like total income and net income across businesses of various sizes. This reveals how business compare in managing their assets and liabilities, income, expenses, and cash flow (regardless of total size).
Vertical analysis can also be used to compare the companies numbers to competitors or the industry averages.
How Is Vertical Analysis Different From Horizontal Analysis?
We already established that vertical analysis looks at the proportional representation of specific line items on financial statements by comparing them as a percentage of the total.
So if a company’s balance sheet had a total of $400,000, and $100,000 of it was accounts receivable, then by using vertical analysis, AR would be 25% of the total assets on the balance sheet.
But analysts are often concerned with a business’s performance over time. Therefore, horizontal analysis looks at changes over time based on different data from the financial statements.
Horizontal analysis differs slightly from vertical analysis in that it presents each item in the financial statements as a percentage of itself at an earlier period in time. This is also sometimes referred to as trend analysis.
It is used to assess a business’s ability to grow its revenue while managing its expenses and to get an idea of how efficient the business is at using its assets, liabilities, and various sources of cash.
Horizontal analysis might be comparing the ratio of variable expenses over a period of three years. That means the variable expenses in the balance sheet of year 2 and 3 are shown as a percentage of variable expenses of year 1.
For example, a company’s variable expenses on year 1, 2, and 3 were $151, then $147, and finally $142.
This would mean that the ratio of years 1, 2, and 3 to year one would be 100%, 97%, and 94%. In this example, the business’s variable expenses have trended downward over the three-year period.
The issue with only performing horizontal analysis is that it presents one line item as it pertains to itself. Therefore, it is important to see the total picture by combining horizontal and vertical analysis.
By doing both of these analyses, you can get an idea of how line items compare to themselves over time and whether those changes make sense in the context of the current time period as well.
How to Calculate Vertical Analysis
When performing vertical analysis each of the primary statements that make up the financial statements is typically viewed exclusive of the other. This means it is atypical to compare line items on the income statement as a percentage of gross income.
That being said, there are some circumstances where cross comparing ratios of certain accounts would make sense. For example, liabilities expressed as a percentage of net income.
When preparing vertical analysis it is common to provide the ratios in a column to the right of the financial statement value. Taking a look at an example income statement, vertical analysis is usually presented as follows:
Notice that the column presenting the ratio of each line item to gross sales is to the right of the actual values. Sometimes, financial statements are prepared in this way by the provider but often FP&A analysts will utilize their own basis depending on what information they are trying to understand.
While each financial statement is viewed differently and the ratios are compared on a different basis, it is common to see the methodology prepared in this way.
Example of Vertical Analysis
Here is an easy example of vertical analysis and how to calculate it.
Let’s go with a simple balance sheet:
- Cash – $40,000
- Accounts Receivable (AR) – $100,000
- Inventory – $80,000
- Property, Plant, and Equipment (PPE) – $180,000
The total assets in the balance sheet would be $400,000.
If the company wants to use vertical analysis to see how their AR is doing, they would calculate AR in percentage of their entire balance sheet which would be 25% ($100,000 of $400,000). If they want to calculate their inventory, it would be 20% while using vertical analysis ($80,000 of the $400,000 total).
Based on competitor or industry analysis they can decide if they need to improve one of their categories in the balance sheet, and then make a plan for how to go about doing it.
Pros and Cons of Vertical Analysis
Like any financial calculation and analysis, vertical analysis is not complete by itself and has pros and cons.
Pros of Vertical Analysis
- Very easy and quick to compare.
- It identifies trends throughout all time periods that you calculate so small seasonal changes and ups and downs aren’t affected (if you are calculating by year, for example).
- It’s a good indicator of potential problems that can be solved quickly. For example if the percentage of costs went up, while sales stayed the same, a red light will go off.
- It also identifies which line item is performing the best and help the company act on it.
Cons of Vertical Analysis
- It’s a very simple overview and doesn’t provide details. For example, why did costs increase? Maybe inflation played a role.
- Vertical analysis doesn’t provide the bigger picture of how a company is doing as it’s very specifically in a balance sheet, cash flow statement, or income statement.
Key Takeaways:
- Vertical analysis is a quick and easy calculation that can be done to gain financial insights.
- Vertical analysis and horizontal analysis compare different things, and are stronger when done together.
- Like any financial analysis or calculation, vertical analysis has its pros and cons.
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