Vertical analysis is a method of analyzing financial statements in which every item is shown as a percentage of a base amount within the same statement and period. On the income statement, the base is normally net sales or total revenue, so each expense and profit figure becomes a share of revenue. On the balance sheet, the base is total assets, or total liabilities and equity, so each asset, liability and equity item becomes a share of the total.
Statements prepared this way are called common-size statements, such as the common-size income statement and the common-size balance sheet. Vertical analysis looks down a single column of figures, which is where its name comes from, and complements horizontal analysis, which looks across periods.
Calculation
Each line is converted with the same formula:
Here is the figure being analyzed, such as cost of goods sold or inventory, and is net sales for the income statement or total assets for the balance sheet. The base itself is always 100 percent.
Worked example
Two sporting goods retailers of very different sizes report the following income statement figures:
| Item | Company A | Percent | Company B | Percent |
|---|---|---|---|---|
| Net sales | $2,000,000 | 100.0 | $90,000,000 | 100.0 |
| Cost of goods sold | $1,180,000 | 59.0 | $58,500,000 | 65.0 |
| Gross profit | $820,000 | 41.0 | $31,500,000 | 35.0 |
| Operating expenses | $660,000 | 33.0 | $22,500,000 | 25.0 |
| Operating income | $160,000 | 8.0 | $9,000,000 | 10.0 |
In dollars, the companies are hard to compare. As percentages, the picture is clear. The smaller Company A earns a higher gross profit margin, perhaps through specialist products and higher prices, but spends a much larger share of sales on operating expenses, so its operating margin is lower. Company B buys and sells at lower margins but benefits from scale in its overheads.
On the balance sheet, if Company A has total assets of $1,200,000, of which $480,000 is inventory, inventory is 40 percent of total assets. If the industry norm is 30 percent, the business may be overstocked.
Uses of vertical analysis
- Comparing companies of different sizes, or a company with industry averages published by trade associations and data providers.
- Tracking a company's own cost structure over time by preparing common-size statements for several years, which combines vertical and trend analysis.
- Understanding the asset mix and capital structure, such as how much of total assets is in current assets or how much is financed by debt.
- Setting budgets and targets as percentages of sales, such as keeping advertising at 4 percent of revenue.
- Highlighting key margins, since the common-size income statement directly shows the gross profit percentage and profit margin.
Limitations
Percentages can hide changes in absolute amounts. An expense can rise sharply in dollars while staying the same percentage of sales if sales grew equally fast. A falling percentage may reflect higher sales rather than lower costs. Comparisons between companies are affected by different accounting policies, such as how costs are classified between cost of goods sold and operating expenses. Industry averages may mix companies with very different business models. Vertical analysis is therefore best used together with horizontal analysis, ratio analysis, comparative financial statements and a reading of the notes.