What Is Vertical Analysis and How Does It Work?

Diving into the financial intricacies of a business often feels like venturing through a complex web of numbers, ratios, and terminology, which more often muddle than clarify. Business owners and financial experts grapple with the challenge of interpreting these figures for strategic direction. A lack of insight into financial health can lead a company to overlook areas of waste, extravagance, or underused assets, resulting in missed opportunities and stunted growth.

Vertical analysis emerges as a beacon in this maze. This method transforms each element in a financial statement into a percentage of a pivotal reference point, like total assets or net sales, to simplify the financial picture and make it easier to compare data.

This article serves as a practical guide, introducing you to the bedrock principles of vertical analysis and its role in managing business finances. Continue reading to discover how vertical analysis can unlock deeper understanding of your company's financial dynamics and refine your strategic decision-making.

What Exactly Is Vertical Analysis?

Vertical analysis, or common-size analysis, offers a streamlined lens to examine financial statements (such as cash flow statements and profit and loss statements). It converts every line item into a percentage of a key number, easing the comparison of different segments of the statement against a unified benchmark.

Typical reference points include total assets, net sales, or total liabilities. For example, in a balance sheet —  which is essentially a financial snapshot of a company's holdings and debts — each asset and liability is recalculated as a percentage of total assets. This could include accounts receivable, inventory, or accounts payable. A similar approach applies to the vertical analysis of income statements, where each revenue and expense is redefined as a percentage of sales (total net sales).

It's important to note the difference between a vertical analysis versus a horizontal analysis. While vertical analysis compares different elements of a single statement, horizontal analysis measures the change in values across multiple time periods. Together, they provide a comprehensive overview of a company's financial performance.

The Importance Of Vertical Analysis

Vertical analysis is a valuable tool for quickly gauging a company's financial health. It simplifies financial data by turning each item into a percentage of a key total figure, making it easier to spot trends and understand where money is going. This approach is particularly useful for examining cost structures and how different revenue streams contribute to overall profit.

Vertical analysis is also very useful for industry benchmarking, allowing for effective comparisons between companies of varying sizes within the same industry or sector. It focuses on proportions, not just raw numbers, offering a clearer picture of a company's performance relative to its peers. This proportional view helps analysts and businesses understand where they stand in the competitive landscape.

How To Conduct Vertical Analysis

As with any other financial analysis, there are several detailed steps to follow when you conduct a vertical analysis. From deciding on the base figure you'll use to calculating and interpreting the results, each step is crucial in ensuring the accuracy and reliability of your analysis.

Identify The Base Figure

The first step in vertical analysis is picking the baseline figure. Think of this as your measuring stick against which all other items will be compared. For income statements, total revenue or net sales are often used as the base figure. This helps you understand how different costs affect your profitability and identify areas for potential cost-saving.

In the vertical analysis of a balance sheet, total assets are often the go-to baseline. This reflects the overall strength of what your company owns, showing how each asset fits into the bigger financial picture. This is especially useful for startups looking to understand exactly how their resources are spread out.

In both cases, selecting an appropriate baseline figure should align with the specific goals of your analysis and the distinct characteristics of your startup's financial position. Ensuring consistent use of the same baseline figure over time is crucial for precise trend analysis and effective performance monitoring.

Calculate The Percentage Of Each Line Item

After choosing your baseline metric, it's time to determine the percentage each line item represents using the vertical analysis formula. It can be expressed as:

VA = Item / Base amount (100)

The formula divides the line item's value by the baseline and multiplies it by 100 to convert it into a percentage. This transformation renders complex financial data into easily interpretable figures.

For instance, when examining an income statement with total revenue as your reference point, the cost of goods sold (COGS) percentage is determined by dividing COGS by total revenue and multiplying the result by 100. This calculation reveals how much of your revenue is allocated to COGS. Consider using a spreadsheet with premade equations or an online vertical analysis calculator to speed up this process.

Express Each Line Item As A Percentage Of The Base Figure

The next step involves embedding these calculated percentages into your financial statements. Place these percentages next to their corresponding dollar amount values to illustrate their relation to the baseline. This practice enhances the understanding of how each financial component contributes to the overall picture.

For instance, beside the administrative expenses on an income statement, you would display its percentage of the total revenue. This method clearly indicates the proportion of revenue spent on administration.

Similarly, on a balance sheet, each asset, liability, or equity item would be shown as a percentage of total assets, quickly conveying their significance in the overall financial structure.

Analyze The Results

Once you have your percentages, it's time to really dig into what they mean for your business. This stage is all about internal assessment and reflection, rather than quick decision-making. You'll look at each percentage and think about how it fits with your company's operations and objectives. Here's what to focus on:

1. Evaluating Resource Use: Check if you're using your resources in the best way. A disproportionately high percentage in one area might suggest an imbalance that could be corrected for better efficiency.
2. Internal Health Check: Use these percentages to perform a health check of your business. If certain costs are trending upward over time, it might indicate areas needing closer attention or a shift in strategy.
3. Setting Internal Benchmarks: Use your findings to set benchmarks or targets, for your business. These benchmarks can serve as goals for future periods, helping to guide your team's efforts and focus.
4. Laying the Groundwork for Deeper Analysis: This is just the beginning. Understanding these basic relationships between the parts of your financials sets the stage for more detailed analyses covered later, such as comparative analysis and financial forecasting. By first understanding the basic proportional relationships within your financials, you lay the groundwork for more complex applications of vertical analysis.

Practical Applications Of Vertical Analysis

Vertical analysis serves as a robust tool in financial management, offering versatile applications that extend beyond basic number-crunching. Its practicality lies in providing a proportional perspective of financial statements, which can be leveraged in various ways for strategic business management. The following section investigates applications for vertical analysis in business decision-making, comparative analysis, and financial forecasting.

Business Decision-Making

Vertical analysis transforms the approach to strategic business decisions. By converting financial data into relative percentages, it provides an uncluttered view of financial health, highlighting areas demanding attention or optimization.

This is especially useful when you're adjusting budgets or moving money around to different parts of the business. For instance, if you notice that a lot of your revenue is being spent on the operating expenses for one department but isn't bringing much back in return, it might be time to think about using those resources elsewhere for better balance and efficiency.

Comparative Analysis

Vertical analysis also excels in comparative analysis, making it easier to see how your business stacks up against competitors. By turning financial numbers into percentages, it levels the playing field, allowing you to compare companies of different sizes easily. This method helps spot where you're doing well and where you might need to catch up.

For example, comparing your cost percentages with those of a growing competitor can reveal if you're spending too much in certain areas or not enough in others. It's like having a financial benchmarking tool that guides you in fine-tuning your strategies. Plus, by analyzing trends over time in these percentages, you can track your progress and adapt to industry trends to keep your business agile.

Develop Financial Forecasts

Vertical analysis offers a reliable basis for developing financial forecasts, providing insight into future performance scenarios. Converting your historical financial data into percentages helps you understand patterns and trends in your spending and earnings. This understanding is crucial for predicting future financial scenarios.

Imagine using these percentages to forecast next year's budget. If a particular expense category has consistently increased in percentage over the past few years, you can estimate its growth for next year. Similarly, if a revenue stream has been declining in percentage, you can adjust your projections accordingly. By combining vertical analysis with other forecasting methods, you can create highly accurate financial forecasts that enable sound decision-making and effective planning.

Analyze Your Finances With Ease

The simplicity and clarity of vertical analysis in breaking down financial data make it a powerful tool for businesses of all sizes. It breaks down complex financial statements into easily digestible percentages, facilitating quick assessments of financial health and operational efficiency. This approach is invaluable for stakeholders at all levels, from management to investors, providing a straightforward way to track financial performance and make informed decisions.

Whether you're aiming to improve resource allocation, benchmark against competitors, or identify potential areas for growth, vertical analysis offers a unique vantage point for analyzing your organization's finances. Alongside traditional financial metrics, such as profitability ratios and liquidity ratios, vertical analysis accounting will get you one step closer to understanding your financials and making data-driven decisions.