Unlike the unadjusted income statement and balance sheet, the common size variations can be used for peer-to-peer comparisons between different companies. Performing vertical analysis creates the so-called “common size” income statement and the “common size” balance sheet. Example of the vertical analysis accounting of the financial statement, which shows the total amount and percentage.
However, these expenses don’t, at first glance, appear large enough to account for the decline in net income. For the balance sheet, the total assets of the company will show as 100%, with all the other accounts on both the assets and liabilities sides showing as a percentage of the total assets number. In accounting, a vertical analysis is used to show the relative sizes of the different accounts on a financial statement. For instance, we can see that our company’s long-term debt as a percentage of total assets is 17.0%.
There is a baseline period and numbers from succeeding periods are calculated as a percentage of the base period. Vertical analysis looks at numbers in financial statements in the same period and calculates each line item as a percentage of the base figure in that section. Vertical analysis, also known as common-size analysis, is a powerful tool used in finance to gain volunteering insights into the financial health and performance of a company. It involves comparing each line item or component within a financial statement to a specific base figure, usually expressed as a percentage.
By doing this, we’ll build a new income statement that shows each account as a percentage of the sales for that year. As an example, in year one we’ll divide the company’s “Salaries” expense, $95,000 by its sales for that year, $400,000. That result, 24%, will appear on the vertical analysis table beside Salaries for year one. The process is virtually identical to our common size income statement, however, the base figure is “Total Assets” as opposed to “Revenue”. Suppose we’ve been tasked with performing vertical analysis on a company’s financial performance in its latest fiscal year, 2021. The formula to perform vertical analysis on the income statement, assuming the base figure is revenue, is as follows.
By comparing the proportions of individual accounts from time period to period, companies can track fluctuations and use them to inform strategic decisions, assisting with financial forecasting. Vertical analysis can also be used to benchmark a company’s performance against industry averages. In vertical analysis, each line item in the financial statement is expressed as a percentage of a base figure in the same period (for example, the total assets or gross sales). However, in horizontal analysis, the relative change in a line item from one period to the next is calculated and typically presented as a percentage change.
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It’s an effective tool for comparing a company’s financials to those of competitors and an industry benchmark because it allows for easy, straightforward comparisons across different periods and companies of varying sizes. 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.
If you want to take your variance analysis to the next level, check out FloQast Variance Analysis. It offers a better way to perform flux and budget variance analysis by automating the data collection process and integrating with your ERP. For each line item on the balance sheet, divide it by the Total Assets and multiply the result by 100.
Vertical Analysis Formula
Despite the various advantages, there are a few factors of vertical analysis accounting that prove to be a disadvantage. Vertical analysis is used in order to gain a picture of whether performance metrics are improving or deteriorating. The same process applied to ABC Company’s balance sheet would likely reveal further insights into how the company is structured and how that structure is changing over time. Because we entered our costs and expenses as negatives, i.e. to reflect that those items are cash outflows, we must place a negative sign in front when applicable, so that the percentage shown is a positive figure.
Step 2. Vertical Analysis of Income Statement
Converting the raw numbers into percentages provides a clearer picture of the proportion of the asset or liability in the context of the company’s total financial resources. The following example shows ABC Company’s income statement over a three-year period. On the liabilities and shareholders equity side, we’ve chosen the base figure to be total assets. Use the insights gained from the vertical analysis taxable income vs gross income in your decision-making processes.
The metric we calculated is formally known as the “debt to asset ratio”, which is a ratio used to gauge a company’s solvency risk and the proportion of its resources (i.e. assets) funded by debt rather than equity. We’ve now completed our vertical analysis for our company’s income statement and will move on to the balance sheet. Vertical analysis, often referred to as common-size analysis, is a crucial financial tool used in the world of business and finance to assess the relative proportions of different financial statement items. Compares figures from multiple years to identify trends, looking at changes over time in different elements of the financial statements.
It enables the accountant to see relative changes in company accounts over a given period of time. From this analysis, we can observe that the gross profit margin is 50%, indicating that 50% of the sales revenue is retained after deducting the cost of goods sold. This insight can help a business evaluate its pricing strategy, production costs, and profit margins. To overcome these limitations, it’s a good idea to use vertical analysis in conjunction with other financial analysis techniques, such as horizontal analysis or ratio analysis, as well as other financial ratios. In ABC Company’s case, we can clearly see that costs are a big reason profits are declining despite the company’s robust sales growth. What we don’t know, and what we can’t know from the vertical analysis, is why that is happening.
- In the 3rd year, the COGS decreased compared to the previous years, and the income increased.
- Vertical analysis is an accounting tool that enables proportional analysis of documents, such as financial statements.
- It allows stakeholders, including investors, analysts, and management, to gain valuable insights into a company’s financial structure and performance.
- Returning to our example above, a vertical analysis of Jackson Widget Company’s balance sheet would look like this.
Let’s look at an example to see how applying the vertical analysis formula might work in the real world. Once the historical data from 2021 has been inputted into Excel, we must determine the base figure to use. Let us understand the advantages of vertical analysis equation through the points below. Horizontal analysis indicates long-term trends and highlights areas of strength and those that need improvement. Vertical analysis indicates the relative importance of each line item in a certain period. Compare your results with industry benchmarks or similar companies to see how your business stacks up.
How to Interpret the Vertical Analysis of a Balance Sheet and Income Statement
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. 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. 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.