Vertical analysis

Financial controllers need ways of analysing the numbers in financial statements to identify correlations between them and to compare the data with competitors. One tool for doing this is vertical analysis. How does it work?

What’s vertical analysis?

Vertical analysis is an accounting tool that enables proportional analysis of financial statements or management accounts. Vertical analysis is different from horizonal analysis which shows corresponding changes in the numbers over a certain period of time. While performing a vertical analysis, every line item on a financial statement is entered as a percentage of another item. For example, on a profit and loss statement, every line item is stated in terms of the percentage of revenue:

Cost of sales
Gross profit
Operating expenses
Net profit

Vertical analysis can also be performed on a balance sheet with every entry shown as a percentage of total assets. On a cash-flow statement, every cash outflow or inflow is relative to the company’s total cash inflows.

Advantages and uses of vertical analysis

Direct comparison between numbers. 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. For example, the board may consider shutting down a particular unit if profit per unit falls below a particular threshold percentage.

Identify insignificant numbers. By undertaking vertical analysis, you can identify expenses which are so small as a percentage of the revenue that they may not be worthy of much management attention.

Identify potential issues. Vertical analysis can help uncover underlying problems such as cost increases that are not aligned with revenue growth.

Compare with competitors. It’s highly effective when comparing two or more companies operating in the same industry but of different sizes. It’s often tricky to compare the balance sheet of a £1 billion company to one that is valued at £500,000. Vertical analysis enables you to create common-size measures so that you can easily compare amounts of different magnitudes.

Limitations of vertical analysis

The limitations of vertical analysis include:

Ignores absolute values. It’s not able to provide any information on the absolute size of various line items so it can be misleading when comparing two companies of different sizes.

Over-emphasis on percentages. Relying solely on percentages may lead to an over-emphasis on small changes in certain line items, especially when the base item is very small. This can result in an inaccurate representation of the significance of those changes.

Tip. For a more comprehensive analysis, it’s often beneficial to combine vertical analysis with horizonal analysis, ratio analysis and industry benchmarks.

With vertical analysis each line item in a financial statement is expressed as a percentage of the base item, e.g. gross revenue or total assets. The board could use the percentages to set targets or to identify expenses that are so small as to not warrant much attention.

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