Vertical Analysis of Financial Statements
Vertical analysis of financial statements is a technique in which the relationship between items in the same financial statement is identified by expressing all amounts as a percentage a total amount. This method compares different items to a single item in the same accounting period. The financial statements prepared by using this technique are known as common size financial statements.
This analysis is performed on the income statement as well as the balance sheet.
- Balance Sheet:
When applying this method on the balance sheet, all of the three major categories accounts (i.e. assets, liabilities, and equity) are compared to the total assets. All of the balance sheet items are presented as a proportion of the total assets. These percentages are shown along with the absolute currency amounts. For example, suppose a company has three assets; cash worth $4 million, inventory worth $7 million and fixed assets worth $9million. The vertical analysis method will show these as
Fixed Assets: 45%
- Income Statement:
And when applying this technique to the income statement, each of the expense is compared to the total sales revenue. The expenses are presented as a proportion of total sales revenue along with the absolute amounts. For example, if the sales revenue of a company is $10 million and the cost of sales is $6 million, the cost of sales will be reported as 60% of the sales revenue.
The main advantage of using vertical analysis of financial statements is that income statements and balance sheets of companies of different sizes can be compared. Comparison of absolute amounts of companies of different sizes does not provide useful conclusions about their financial performance and financial position.
Usually the vertical analysis is performed for a single accounting period to see the relative proportions of different account balances. But it is also useful to perform vertical analysis over a number of periods to identify changes in accounts over time. It can help to identify unusual changes in the behavior of accounts. For example, if the cost of sales has been consistently 45% in the history, then a sudden new percentage of 60% should catch the attention of analysts. Reasons behind this change should be investigated and then measures should be taken to bring this percentage back to its normal level.