Vertical Analysis of Financial Statements
Vertical analysis (also known as common-size 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 vertical analysis of financial statements is that it allows the income statements and balance sheets of companies of different sizes to be compared. A comparison of absolute amounts between companies of different sizes does not provide useful information about their financial performance and financial position.
Typically, vertical analysis is performed for a single accounting period to see the relative proportions of different account balances. However, 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 behaviour of accounts. For example, if the cost of sales has consistently been 45% in the past, then a sudden new percentage of 60% should catch the analyst's attention. The reasons for this change should be investigated and action taken to bring the percentage back to its normal level.
Example of Vertical Analysis
Here's an example of vertical analysis of a company's balance sheet:
|Percentage of Total Assets
|Cash and Cash Equivalents
|Property, Plant & Equipment
|Less: Accumulated Depreciation
|Net Property, Plant & Equipment
In this example, total assets are used as the base item, and each line item is expressed as a percentage of total assets. The table shows that current assets represent 40% of total assets, with cash and cash equivalents representing 10%, accounts receivable representing 20%, inventory representing 10%, and prepaid expenses representing 2%.
Non-current assets represent 60% of total assets, with property, plant & equipment representing 40%, less accumulated depreciation representing -10%, and net property, plant & equipment representing 30%. Intangible assets represent 10% of total assets.
By using vertical analysis, we can see that current assets represent a significant portion of total assets at 40%. We can also see that property, plant & equipment represents the largest single category of non-current assets at 40% of total assets. This analysis can help identify areas of strength or weakness in a company's asset composition, and can be useful for comparing the asset composition of different companies or tracking changes in a company's asset composition over time.
Limitations of Vertical Analysis
Vertical analysis is a useful technique for analyzing financial statements, but it has some limitations, including:
- Limited Context. Vertical analysis only provides information about the relative proportion of each line item to a base item, and does not provide any context about the company's financial performance or external factors that may be affecting the company.
- Lack of Comparison. Vertical analysis is typically used to analyze a single period, and it does not allow for comparison between periods or between companies.
- Incomplete Picture. Vertical analysis only looks at individual line items and does not provide a complete picture of the company's financial performance or position.
- Potential Distortions. Vertical analysis can be distorted if there are significant changes in the base item, such as changes in net sales or total assets.
- Ignoring Inter-relationships. Vertical analysis does not consider the inter-relationships between different line items, and thus may not capture the overall financial health of the company.
- Difficulty in Interpretation. Vertical analysis may not be easily interpreted by non-experts, as it requires a deep understanding of the financial statements and ratios.
- Dependence on Accounting Standards. Vertical analysis is dependent on the accounting standards used to prepare the financial statements, and different accounting standards may affect the results of the analysis.
Therefore, while vertical analysis is a useful tool for financial analysis, it should be used in conjunction with other techniques and should not be relied on as the sole method for evaluating a company's financial performance.
Vertical Analysis vs. Horizontal Analysis
Vertical analysis and horizontal analysis are both techniques used to analyze financial statements, but they differ in the way they present information.
Vertical analysis is a technique that evaluates the relative proportions of each line item in a financial statement to a base item, such as net sales or total assets. The purpose of vertical analysis is to assess the relative importance of each line item and to identify trends and patterns over time. Vertical analysis presents data in a single time period by expressing each line item as a percentage of the base item. This allows for easy comparison of the relative importance of each line item within a single time period.
Horizontal analysis, on the other hand, is a technique that compares financial statement data over multiple periods to identify changes or trends over time. Horizontal analysis presents data for multiple time periods side by side, typically in the form of percentage changes or dollar changes. This allows for easy comparison of financial statement data over time to identify changes in the company's financial performance.
So, vertical analysis focuses on presenting data in a single time period as a percentage of a base item, while horizontal analysis focuses on comparing data over multiple time periods to identify trends and changes over time.