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What Is Vertical Analysis?
Let me explain vertical analysis directly: it's a method where you express each line item in financial statements as a percentage of a base figure. For instance, on a cash flow statement, you'll see each inflow or outflow as a percentage of total cash inflows. On an income statement, line items become percentages of gross sales, and on a balance sheet, they're percentages of total assets or liabilities. This approach helps you understand how each part contributes to the whole.
Key Takeaways
Here's what you need to grasp: vertical analysis examines the percentage each line item contributes to the base figure in financial statements. It clarifies the relationship between individual items on a balance sheet and the bottom line, all in percentage terms. You'll find it even more powerful when paired with horizontal analysis, which looks at finances over specific time periods.
How Vertical Analysis Works
Vertical analysis simplifies comparing financial statements between companies and across industries by revealing the relative proportions of account balances. It also aids in time series analysis, where you compare quarterly or annual figures over years to assess if performance is getting better or worse. For example, expressing expense items as percentages of sales shows their impact on profit margins and whether profitability is improving, making it straightforward to benchmark against peers.
Financial statements with vertical analysis display line item percentages in a separate column. These are often called common-size financial statements, which many companies use for a clearer picture of their financial position. They frequently include comparisons to prior periods as well.
Vertical vs. Horizontal Analysis
Now, contrast this with horizontal analysis, also known as trend analysis. In horizontal analysis, you compare ratios or line items over time, using one year's figures as a baseline and expressing others as percentage changes from that base. For cash on a balance sheet, you might see figures like 141%, 135%, etc., indicating growth relative to the baseline year. This lets you track how each item evolves in relation to others.
Example of Vertical Analysis
Take XYZ Corporation with $5 million in gross sales, $1 million cost of goods sold, $2 million in general and administrative expenses, and a 25% tax rate. Using vertical analysis, the income statement shows sales at 100%, cost of goods sold at 20%, gross profit at 80%, expenses at 40%, operating income at 40%, taxes at 10%, and net income at 30%. This breakdown directly illustrates each component's share of total sales.
What Is the Difference Between Horizontal and Vertical Analysis?
Horizontal analysis compares historical data across periods, using a base period and expressing subsequent figures as percentages of it to show long-term trends and areas for improvement. Vertical analysis, however, focuses on a single period, calculating each line item as a percentage of the base in that section to highlight relative importance.
What Is an Example of Vertical Analysis?
Suppose a company sold 40,000 units, with 14,000 sneakers and 26,000 boxing gloves. Vertical analysis reveals sneakers as 35% of sales and boxing gloves as 65%, giving you a clear view of product contributions.
What Are the Pros and Cons of Vertical Analysis?
One advantage is that vertical analysis enables comparisons across periods and companies by focusing on percentages. A downside is it ignores absolute numbers, so comparing two firms via percentages might differ from using raw figures.
The Bottom Line
In summary, vertical analysis calculates each line item's percentage contribution to the total base, helping you identify improving or worsening metrics. It supports comparisons between company components, across firms, and over time periods.
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