The vertical analysis provides a correlation between one line item in a financial statement and its top-line or baseline item.
It is calculated by adding a column in the financial statement and the results are shown in percentage terms. It offers valuable information to internal and external stakeholders and can be used in different situations.
Let us discuss what is vertical analysis, how to perform it, and what are the advantages and disadvantages of this method.
Vertical Analysis – Definition
Vertical or proportional analysis refers to an accounting method where each line item in a financial statement is compared against another in the same statement.
In this type of analysis, each line item is represented as a percentage of another item. Usually, a baseline item is selected and all other items are reported in percentage terms of that item.
Vertical analysis is a common tool to analyze financial statements comparatively in a single accounting period.
Therefore, if you want to compare the performance of a company across accounting periods, you’ll have to conduct separate vertical analyses for each accounting period.
Vertical analysis can be performed for the income statement, balance sheet, and cash flow statements. However, the most common use is for income statement analysis like comparing line items against gross sales or balance sheet items.
How Does Vertical Analysis of Financial Statements Work?
Vertical analysis can be used for internal performance evaluation or external benchmarking. The proportional description of line items on a financial statement makes it easier to compare figures.
Converting static figures into percentages in terms of the baseline item helps create a trend series. Analysts can then use it for internal performance evaluation across multiple accounting periods.
Once the financial statement figures are described in percentage terms, you can easily compare them against industry averages for standardization and benchmarking.
Analysts prepare percentage terms for each line item in all major financial statements. The financial statements created with vertical analysis are termed common-size financial statements.
Common-size financial statements are not a statutory requirement. Managers add an extra column to show each line item as a percentage of the top-line item. It helps them expand the analysis beyond static figures.
Then, analysts can establish whether the financial metrics improved from the previous periods or not.
How to Perform Vertical Analysis?
Vertical analysis shows results in a percentage term for the current accounting period only. It creates a link between the baseline item and other line items in the statement.
Vertical Analysis Value = (Line Item in a statement/Baseline item in the statement) × 100.
You can calculate a vertical link for any item in a financial statement using this formula to compare against the baseline item or with the figures from the previous accounting cycle.
Step 01:
The first step is to determine the baseline item in a financial statement. Usually, it is revenue from the income statement and assets or liabilities from the balance sheet.
Step 02:
The next step is to select the line item for comparison calculation.
Step 03:
Then, you can simply take both figures and use them in the formula given above to find the relationship between both.
Example
Let us understand the concept with the help of an example.
Facebook’s parent company Meta inc. Reported a gross revenue figure of $117,929 million for the year ended 2021. The company reported a net profit of $ 39,730 million.
We can compare both these figures to analyze its net profit margin ratio.
Vertical Analysis Value = (Line Item in a statement/Baseline item in the statement) × 100.
Vertical Analysis Value = ($ 39,730/ $ 117,929) × 100 = 33.68%
The standalone figures do not reveal much. We can use the same method to calculate these values for the previous year from Facebook’s financial statements for better understanding.
Meta Inc. Gross Revenue for 2020 = $ 29,146 million Net Profit = $ 85,965 million
Vertical Analysis Value = ($ 29,146 / $ 85,965) × 100 = 33.90%
We can now understand that although the gross revenue and net profit figures have improved for Facebook, the net profit margin percentages are similar.
Vertical Analysis and Stock Investments
Investors can use vertical analysis to analyze a stock and compare it against other potential investment options as well.
Continuing from our example above, if we see gross revenue and net profit figures for Facebook, we can assume these figures improved drastically.
With the help of vertical analysis, as shown above, we can argue that the net profit margin for Facebook remained similar to that of the previous year.
Similarly, an investor can take other line items from the income statement or balance sheet to conduct further research on a stock. These results can then be compared for historic performance analysis of the stock or against the industry benchmarks.
However, like horizontal analysis, this type of analysis also provides limited information. It must be analyzed in conjunction with other methods for better understanding.
Reporting Standards and Vertical Analysis
The creation of common-size financial statements is not compulsory. The Generally Accepted Accounting Principles (GAAP) do not require adding the percentage column.
However, the vertical analysis provides a clearer understanding of the static figures in all types of financial statements.
Advantages of Vertical Analysis
The vertical analysis provides several advantages to internal and external stakeholders of a company.
- Financial statement line items represented in percentage terms are easier to understand and interpret than static figures.
- Percentage terms create a correlation between the top-line (or baseline) item and other line items.
- It can be used for internal performance evaluation as well as external benchmarking.
- Managers can use this method to analyze the performance of different divisions/operational segments of the company.
- The use of percentage terms in vertical analysis helps managers to set threshold performance metrics.
- It helps managers scale financial statement items to compare against other companies in the same industry but with different sizes.
- The calculations are fairly easy and simple to understand.
Disadvantages of Vertical Analysis
Despite several advantages, vertical analysis comes with some disadvantages too.
- Apart from a few key financial ratios like net profit margin, there are no standardized ratios in the vertical analysis.
- The results fail to answer the “Why” behind the results. It means this method does not explain the causes of a positive or negative change in a financial ratio.
- Like horizontal analysis, this method also provides historic performance analysis which may change over time with accounting adjustments.
- Managers can distort and manipulate key financial figures by using accounting loopholes.
- Seasonal fluctuations and temporary changes do not reflect properly in a vertical analysis.
Vertical Analysis Vs Horizontal Analysis – Key Differences
Both horizontal and vertical analysis provides useful information for stakeholders of a company. They can be used in different situations and the best interpretation may come from a combined approach from both these methods.
The key differences arise from the way both these analysis methods are used.
First, horizontal analysis analyzes the company’s performance over several accounting periods. The vertical analysis analyzes for one accounting period only.
Second, the horizontal analysis provides results on a year-by-year or time basis, the vertical analysis shows results in percentage terms.
Third, horizontal analysis is more common when appraising the performance of a company against its historic results whereas vertical analysis is common for external benchmarking analysis.
Fourth, horizontal analysis can be calculated in absolute terms or percentage terms as desired. However, vertical analysis is only calculated in a percentage term.
Both these analysis methods have some similarities as well.
- Both methods can be used by internal stakeholders like managers as well as external stakeholders like lenders.
- Both methods can help establish trend analysis and visualize the financial results of a company.
- These methods provide a historic perspective as these are not forward-looking analyses.
