Vertical Analysis: What It Is, Why It’s Important, Examples, Plus Pros and Cons

What Is Vertical Analysis?

Vertical analysis is a technique used in financial statement analysis to show the relative size of each account compared to the total amount. Vertical analysis expresses each item on a financial statement as a percentage of the total. Vertical analysis makes it easier to compare companies with different levels of sales or assets by expressing them as percentages rather than absolute amounts. This method can be used for balance sheets, income statements and cash flow statements.

To perform vertical analysis, all items are expressed as a percentage of one base figure from the same year-end financial statement. For example, vertical analysis might express an asset, liability or equity account as a percentage of total assets, liabilities or equity respectively.

Why Is a Vertical Analysis Important?

Vertical analysis is important because it helps stakeholders understand the relative proportions of accounts and performance in relation to each other. It gives business owners a more detailed view of their financial health than just knowing their total assets, liabilities and equity. By comparing the proportions of individual accounts from period to period, companies can track fluctuations and use them to inform strategic decisions. Vertical analysis can also be used to benchmark a company's performance against industry averages.

What Is the Difference Between Vertical and Horizontal Analysis?

Vertical analysis (or common-size analysis) and horizontal analysis (also known as trend analysis) are two of the most commonly used tools in financial statement analysis. Vertical analysis looks at the proportional representation of each line item on the income statement, balance sheet or cash flow statement by expressing them as a percentage of total sales.

Horizontal analysis, on the other hand, looks at changes over time in different elements of the financial statements, such as revenue, expenses and net profit. It is done by comparing figures from multiple years to identify trends. This helps to determine whether a company’s performance has been improving or declining over time due to various factors, such as competitive pressure and new product launches. By using both vertical and horizontal analyses, businesses can gain a better understanding of their financial position and performance.

Advantages of Vertical Analysis

The advantages of vertical analysis include:

• It allows one to easily compare the relative size of different line items on the financial statement, throughout all periods.
• One is able to identify important trends in relation to sales growth or contraction as well as other key elements.
• It helps spot potential problems that may be hidden beneath the surface, such as an increase in costs without corresponding increases in revenue.
• A comparison between various segments under an organization can also be done quickly and accurately through vertical analysis since each segment’s expenses are expressed as a percentage of total sales for the entire organization.
• Vertical analysis helps identify which segments are performing better than others and therefore, helps managers in making decisions.

Disadvantages of Vertical Analysis

The disadvantages of vertical analysis include:

• It is not able to provide any information on the absolute size of various line items, so it can be misleading when comparing two companies of different sizes.
• It does not take into account inflation or other external factors that may cause changes in figures year on year.
• Vertical analysis cannot provide a clear picture of how well a company is doing overall since it only looks at individual components and their proportions within the financial statement.
• Additionally, transactions between related parties, such as subsidiaries, are often excluded from the calculations due to complexities in the accounting process.

Vertical Analysis Example

Let's say that a company has the following balance sheet:

Assets

Advantages of Incremental Budgeting

• Cash: $125,000
• Accounts Receivable: $90,000
• Inventory: $150,000
• Equipment: $150,000
• Total Assets: $515,000

Using vertical analysis on this balance sheet would mean calculating each account as a percentage of total assets. For example, cash would be 24.2% of total assets ($125,000 / $515,000), accounts receivable would be 17.5% of total assets ($90,000 / $515,000), inventory would be 29.1% ($150,000 / $515,000) and equipment would be 29.1% ($150,000 / 515,000).

Conclusion

Vertical analysis is a useful tool for financial statement analysis and helps businesses gain insight into their financial position and performance. However, it has certain limitations that should be taken into account when relying on its output. It is important to combine vertical analysis with other analytical tools, such as horizontal analysis, in order to get a more complete picture of an organization’s financial health.

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