Vertical analysis is the comparison of financial statements by representing each line item on the statement as a percentage of another line item. This type of analysis 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. This uses a fixed point of reference that is used for comparison purposes. For example, on the income statement, if the base chosen is revenue, then each line item would be expressed as a percentage of revenue. The base may also be net income or total gross income for an income statement. On a balance sheet this might mean showing a percentage of either total assets, liabilities, or equity.
By showing each line item as a percentage of an important total this allows analysts to quickly identify correlations, while simultaneously 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).
How Is Vertical Analysis Different From Horizontal Analysis?
Analysts are often concerned with a business’s performance over time and as a result, have a need to perform analysis over a period of time. This is referred to as horizontal analysis.
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. Let us assume that variable expenses on year 1, 2, and 3 were $151, $147, and $142 respectively.
This would mean that the ratio of years 1, 2, and 3 to year one would be 100%, 97%, and 94%, respectively. 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 this analysis 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.
Practical Application Of 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 times where cross comparing ratios of certain accounts would make sense, liabilities expressed as a percentage of net income for example.
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.
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