Vertical analysis simplifies the correlation between single items on a balance sheet and the bottom line, as they are expressed in a percentage. A company’s management can use the percentages to set goals and threshold limits.
The relationship between items in the same financial statement is determined through a technique called vertical analysis, which expresses all amounts as a percentage of the total amount. With this approach, various items from the same accounting period are contrasted with a single item. Common size financial statements are the name given to the financial statements created using this technique.
Typically, a single accounting period is used for the vertical analysis to determine the relative proportions of various account balances. But in order to spot changes in accounts over time, it is also helpful to perform vertical analysis over a number of periods. It can be used to spot suspicious changes in account behavior. For instance, if the cost of sales has historically been 45%, a sudden new percentage of 60% should draw analysts’ attention. After looking into the causes of this change, steps should be taken to return this percentage to the previous level. Share:
Vertical Analysis | Financial Statement Analysis
When is a vertical analysis used?
Vertical analysis is a tool that business managers and financial experts can use to compare costs within a budget. They could specifically aid you in better comprehending how each component of a larger financial statement affects total spending or income. They often do this within a certain period. For instance, a vertical analysis could be carried out as part of a quarterly company review to better comprehend how each department is spending its money.
While vertical analysis compares things within a specific time frame, it can also be helpful to compare things over time. This might make it possible for financial experts to comprehend how altering specific budgetary items has changed the overall monetary baseline from one financial period to the next. This can be helpful when speculating, developing strategies, or determining how to allocate funds in the future.
What is vertical analysis?
Accounting and budgeting experts use vertical analysis as a tool to comprehend financial statements. You can list each line item on the financial statement as a percentage of the total underlying amount to perform vertical analysis. When making a budgeting plan, for instance, you might list each expense as a percentage of the overall budget. Alternatively, the percentage of total income that each line item on a statement of income represents may be included.
What are some advantages of vertical analysis?
Understanding the relationship between each line item on a budget or spreadsheet and the budget’s overarching goal can be made simpler by vertical analysis. Here are some examples of how this might be advantageous:
You can make comparisons within a company
Comparing the financial statements and budgets of various departments within an organization can be made much simpler by vertical analysis. To understand how much of the overall budget two different departments are spending on personnel, for instance, you could use the percentage calculated during the vertical analysis process. This is one instrument that chief financial officers (CFOs) and company managers can use to evaluate their business spending.
You can make comparisons between companies
This tool can also be useful for comparing businesses, including those in the same industry and those in different ones. Even if the products or methods of sale are different, two businesses from different industries can compare their earnings using the percentages of the whole. In this way, vertical analysis is a potent tool that may aid people in comprehending the financial standing and organizational structure of their company in relation to its industry and the business world.
You can create a better business strategy
Financial managers can benefit from using vertical analysis to better understand how money is spent. They could use this to gauge the effectiveness of their current financial plan. One way to do this is to contrast the financial value of a line item’s success overall with the amount of money allocated to that line item.
A financial team might examine the outcomes to determine the effectiveness of a marketing campaign, for instance, if it consumed 15% of the project’s marketing budget. They may continue or expand that campaign if they decide it was worth 15% of the budget. If they determine that the money might have been better spent elsewhere, they may decide to reallocate the money or use the knowledge to create a better marketing and financial plan for the future.
You can communicate about finances more easily
One benefit of vertical analysis is that it makes the overall financial statement and the impact of each line item simpler. Because of this, talking about money with people who don’t work in finance might be simpler. For internal business matters like cross-departmental meetings, company reports, or presentations, this can be helpful. It can be helpful when corresponding with people outside the company, such as investors or media outlets.
What are some disadvantages of vertical analysis?
Vertical analysis is advantageous, but there are some drawbacks to it. It might be beneficial to combine it with another financial analysis technique when conducting analyses. Here are some disadvantages of vertical analysis:
Lack of standardized percentages
You might only take into account a particular group of line items in a vertical analysis when compared to the overall financial total. As a result, these analyses might not provide enough context for you to compare your findings using standardized percentages. You might not be able to interpret that data more clearly by looking at the percentage that each item represents.
You might look for guidelines regarding standardized or suggested percentages for various line items in some types of financial statements. This procedure can be time-consuming and might not be offered for more specialized industries or document types. This type of standardized analysis might only be useful if you have standardized percentages to compare your results to.
Not helpful in liquidity measurements
A company can assess its ability to pay debts and maintain financial viability using a liquidity measurement or ratio. This is a crucial financial tool for a business, and conducting a vertical analysis does not advance our understanding of it. This is an excellent illustration of a scenario where financial officers might need to combine vertical analysis with other financial tools, like trend analysis or ratio assessments, to compile a thorough understanding of their company’s financial standings.
Simplicity over quality
Although vertical analysis is very useful for making a financial statement simpler, it may do so at the expense of some significant factors. For instance, it might not convey the significance of a specific line item, the amount of work that went into developing it, or why it is significant. This means that financial analysts can improve the quality of their findings when using vertical analysis by taking into account factors other than the percentages found during the process.
No explanation of “why”
Vertical analysis results in concrete mathematical data as percentages. While this may aid in your comprehension of the events depicted in financial statements, it might not explain why they take place. For instance, you could use vertical analysis to determine from a company’s income statement that a specific project contributed a significant amount to the quarter’s gross income. The vertical analysis might not address the company’s success drivers and potential future growth strategies. You might need to add to the work with a unique type of analysis to comprehend this.
FAQ
What are the benefits of vertical and horizontal analysis?
Due to the lack of a standard percentage or ratio for the components of the balance sheet and income statement, it is difficult to make a firm decision. Such an analysis does not strictly adhere to accounting principles and practices. It does not help in measuring liquidity.
What are the advantages of horizontal analysis?
While vertical analysis typically concentrates on one reporting period, horizontal analysis typically examines multiple reporting periods. You can compare a company’s current financial situation to its previous financial situation using a horizontal analysis, and you can compare the financial situation of one company to that of another using a vertical analysis.
Is vertical analysis effective?
The primary benefit of using horizontal analysis is that it makes it possible to visually identify anomalies from long-term trends. Comparative data presentation makes changes in the data easier to spot. Additionally, the application of horizontal analysis facilitates future trend projection.
