Vertical analysis offers several strategic benefits to businesses, aiding in better decision-making, financial management, and strategic planning.
Vertical analysis is a method used in financial statement analysis where each line item in a financial statement is listed as a percentage of a base figure within the statement. This technique is often used to analyze the income statement and balance sheet of a business. We will tell you how it works and why it's useful.
Income Statement
In the income statement, vertical analysis expresses each line item as a percentage of total sales (revenue). For example:
If total sales are $100,000 and the cost of goods sold (COGS) is $60,000, then COGS would be 60% of total sales.
Other expenses like operating expenses, taxes, and net income would also be expressed as a percentage of total sales.
Balance Sheet
In the balance sheet, vertical analysis expresses each item as a percentage of total assets. For example:
If total assets are $500,000 and cash is $50,000, then cash would be 10% of total assets.
Liabilities and equity items are similarly expressed as a percentage of total liabilities and equity.
Benefits of Vertical Analysis
Comparability: It allows for easy comparison of financial statements of different companies regardless of their size, as it standardizes the data.
Trend Analysis: By comparing vertical analysis percentages over several periods, trends can be identified. For instance, an increasing percentage of cost of goods sold could indicate rising production costs.
Focus on Proportions: It highlights the relative proportion of account balances. For example, a high percentage of debt compared to equity may indicate higher financial risk.
Steps to Perform Vertical Analysis
Select the Base Figure:
For the income statement, this is usually total sales.
For the balance sheet, this is total assets.
Convert Each Line Item to a Percentage:
Divide each line item by the base figure and multiply by 100 to get the percentage.
Analyze the Results:
Compare the percentages to historical data or industry benchmarks to identify trends and anomalies.
Vertical analysis provides a clear and concise way to present financial data, making it easier to interpret and understand the financial health and operational efficiency of a business.
Strategic Benefits of Vertical Analysis
Enhanced Comparability
Internal Comparisons: Allows businesses to compare financial statements across different periods, identifying trends and changes within the company.
External Comparisons: Facilitates comparisons with other companies in the industry, regardless of their size, by standardizing financial data into percentages.
Improved Financial Management
Cost Control: Identifies areas where expenses are increasing disproportionately relative to sales or assets, helping in controlling and reducing costs.
Resource Allocation: Assists in determining whether resources are being allocated efficiently by highlighting the proportion of different expense categories.
Trend Analysis
Identifying Trends: Helps in spotting trends over time, such as increasing sales, rising costs, or declining profitability.
Predictive Insights: By observing historical trends, businesses can make informed predictions about future financial performance and plan accordingly.
Strategic Planning and Decision-Making
Setting Benchmarks: Establishes internal benchmarks for financial performance that can be used to set goals and evaluate progress.
Informed Decisions: Provides clear insights into which areas are performing well and which require attention, aiding strategic decision-making.
Budgeting and Forecasting: Assists in creating more accurate budgets and forecasts by understanding the proportion of each cost and revenue component.
Identifying Strengths and Weaknesses
Strengths: Highlights areas where the company is performing well, such as high gross profit margins or efficient asset utilization.
Weaknesses: Identifies weak areas, such as high operating expenses or excessive debt levels, prompting corrective actions.
Improved Communication
Stakeholder Communication: Simplifies financial statements, making it easier to communicate financial health and performance to stakeholders, including investors, creditors, and board members.
Internal Reporting: Facilitates clearer internal reporting and discussions among management, enhancing strategic planning and operational decisions.
Risk Management
Financial Risk: Helps in identifying potential financial risks, such as increasing leverage or declining liquidity, allowing for proactive risk management.
Operational Risk: Highlights inefficiencies and cost overruns that could pose operational risks, enabling timely interventions.
Regulatory and Compliance
Compliance Monitoring: Assists in monitoring compliance with financial regulations by providing a clear view of financial performance and structure.
Regulatory Reporting: Simplifies the preparation of financial reports for regulatory purposes by standardizing data into easily understandable percentages.
Conclusion
Vertical analysis is a powerful tool that provides strategic benefits by enhancing the comparability of financial statements, aiding in financial management, enabling trend analysis, improving decision-making, and identifying strengths and weaknesses. These benefits collectively contribute to more informed strategic planning and better overall financial health and performance of the business.