What is a vertical analysis? (including a handy guide)

It's sometimes necessary to analyse a business's assets, liability, expenses and capital. You can do this with tools such as horizontal analysis, vertical analysis and ratio analysis. Knowing how to use such tools can help you when calculating a company income statement. In this article, we discuss vertical analysis and how to use it for income statements and balance sheets.

What is vertical analysis?

Vertical analysis is a method for organising a financial statement, by listing each item as a percentage of a base figure. The first line represents 100% and each subsequent line represents a percentage of the base figure. You can use vertical analysis (VA) to calculate both an income statement and a balance sheet. Each line item of an income statement represents a percentage of the gross sale, while each line item of a balance sheet is a percentage of the total cash flow.

The table below gives an example of an income statement presented as a VA:

You can observe that the first line is the gross total of the entire financial statement, while every other line is a percentage of the gross total.

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How does VA work?

You can use VA in an income statement and balance sheet to understand how items relate to the total/base value. You can also use it to understand trends over a given period and compare two organisations of different sizes.

They're calculated by using the percentage value, which makes the resulting data easier to understand. Using the percentage approach makes it easier to deduce the proportion of each individual item line and compare trends and the account balances of different companies. You can find the percentage of each line item by dividing the value of that item by the total value, multiplied by 100.

Uses and advantages of VA in accounting

VA helps in understanding the relationship between individual items on a balance sheet. VA is more useful when used in conjunction with horizontal analysis. In accounting, VA ascertains the relative proportion of the balance of each account in a single period, be it quarterly or yearly. It also helps chart a regressive or ratio trend analysis. The accountant can see the relative change in the company account over a given period.

Accountants generally prefer VA to other forms of analysis, for the following reasons:

• You can use it to compare a company's financial statement with the average trends within the industry. Here you use percentage comparison rather than the actual value (the actual value makes it difficult to understand the average trend).

• The process of setting goals and making decisions becomes easier for the company management. This is because VA simplifies the relationship between individual items on a balance sheet and the base item, making it easier to spot unproductive units.

• It provides more insight into a company financial statement when compared to horizontal analysis, which only shows the economic changes within a particular unit over a period.

• It's more effective in industrial comparison. For example, comparing two companies of different financial sizes according to actual value can be challenging, but VA creates a standard measure to compare companies of varying financial sizes within the same industry.

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The formula for VA

You calculate VA by dividing an individual item by the base amount, and multiplying by 100:

VA= Individual Item/Base Amount*100

In an income statement, the base amount is Total Sales:

Income statement=Individual Item/Total Sales*100

In a balance sheet, the base amount is Total Assets:

Balance sheet=Individual Item/Total Assets*100

VA for income statement

In a VA for an income statement, you represent each statement line as a percentage of the gross value or total sales. This is also known as a common-size income statement. It's commonly used in accounting due to the following reasons:

• It eliminates the base effect of the scale of operation by expressing the expense account as a percentage. Thus it's an effective tool for comparing the performance of companies of different operation scales.

• It's effective in identifying any sudden change in the company's profitability by indicating the proportionality of accounts.

• It's effective in assessing a company's performance trend over a given period.

You can calculate the VA for the income statement by dividing an item in the income statement by the total sales multiplied by 100:

VA= Income Statement Item/Total Sales*100

Example: The table below is the annual financial report (in millions of US Dollars) of XYZ Ltd, a manufacturing company that manufactures components for different office-ware production companies.

To calculate the VA for the year 2019 in the above report, we use the formula:

VA=Individual item/Total Sale*100

Here is the result below:

Similarly, we can calculate the VA for 2020 using the same formula, with the following result:

You can deduce from the example above that the gross profit has remained relatively stable while there is an increase in operating income in the year 2020 due to a decrease in PT&A expenses. There is also an improvement in the Net income margin due to an improvement in the operating income.

Limitations of VA for income statements

VA for the income statement has limits. These include:

• It has no generally accepted benchmark to determine the proportion of each line item individually.

• Organisations that experience a sudden seasonal increase in revenue cannot use this technique.

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Vertical analyses for balance sheet

You can calculate VA for the balance sheet using the formula:

Balance sheet=individual item/total assets*100

VA for the balance sheet is helpful to see how an organisation account balance changes over a given period. It's necessary to prepare the balance sheet before performing the VA. After that, express the individual item in the statement as a percentage using the formula above. Lastly, you can compare the data to that of similar companies to understand performance. You can also compare it with previous data to know how the organisation account balance has changed over time.

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VA vs horizontal analysis

There are key differences between vertical and horizontal analysis. VA is a way of analysing financial statements using the method of proportion, by calculating each item in a financial statement as a percentage of the total or base value. Horizontal analysis compares historical financial information over a given period and is helpful in analysing price fluctuations in a financial statement and the reasons for such changes.

VA thus compares values in a given report. In contrast, horizontal analysis deduces value from recorded financial reports over a given time. Also, while VA has multiple uses, the horizontal analysis focuses on financial fluctuations. Still, by combining VA with horizontal analysis, we can gain deeper insight into a company financial statement.

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VA vs ratio analysis

Ratio analysis is a method for calculating different financial ratios such as profit margin, inventory turnover and account receivable to sales. You can compare these ratios with other companies' values or a set benchmark. There are different approaches to calculating a single ratio analysis. The inconsistencies in ratio analysis make it the least popular of the three standard financial analysis methods.

While VA is useful in the proportional calculation of each item in a financial statement, ratio analysis compares a financial item across different organisations. For example, you can compare the production cost from company A to that of company B or a set benchmark. Also, while you can calculate VA using a percentage value, you can calculate ratio analysis using a ratio value.

Related:

• What are the three types of trend analysis? (With benefits)