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What is Vertical Analysis?

Vertical Analysis

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Vertical Analysis

Vertical analysis is a method of financial statement analysis in which each line item is listed as a percentage of a base item. In the income statement, this base item is usually net sales or revenue, whereas in the balance sheet, it is generally total assets. This technique allows for easy internal and external comparisons and is particularly useful for understanding the relative proportions of account balances.

How It Works:

  • Income Statement: In the case of the income statement, each item is often expressed as a percentage of total revenue or net sales. For example, if revenue is $100,000 and cost of goods sold is $60,000, then COGS would be 60% when conducting a vertical analysis.
  • Balance Sheet: On the balance sheet, each line item is typically expressed as a percentage of total assets. So, if total assets amount to $200,000 and liabilities are $50,000, liabilities would represent 25% of total assets in a vertical analysis.

Importance:

  • Comparability: One of the key advantages of vertical analysis is that it allows for comparability. By converting everything to percentages, you can easily compare your financial statements with those of other companies, regardless of size.
  • Trend Analysis: Vertical analysis can also be useful for tracking changes within a company over time. If certain expenses are increasing as a percentage of revenue, this could be a red flag that costs are rising faster than income.
  • Budgeting and Planning: Understanding the percentage allocations can aid in more effective budgeting and forecasting, helping management to allocate resources more efficiently.

Example of Vertical Analysis

Let’s walk through a detailed example of vertical analysis using a simplified balance sheet and income statement of a hypothetical company, ABC Corp.

Balance Sheet of ABC Corp as of Dec 31, 2022 (in dollars)

  • Total Assets: $100,000
  • Liabilities:
    • Accounts Payable: $10,000
    • Long-Term Debt: $20,000
  • Equity:
    • Common Stock: $50,000
    • Retained Earnings: $20,000

Vertical Analysis of Balance Sheet:

To conduct vertical analysis, we’ll express each line item as a percentage of Total Assets ($100,000):

  • Accounts Payable: $10,000 / $100,000 x 100 = 10%
  • Long-Term Debt: $20,000 / $100,000 x 100 = 20%
  • Common Stock: $50,000 / $100,000 x 100 = 50%
  • Retained Earnings: $20,000 / $100,000 x 100 = 20%

Income Statement of ABC Corp for the Year Ended Dec 31, 2022 (in dollars)

  • Revenue: $150,000
  • Cost of Goods Sold (COGS): $90,000
  • Gross Profit: $60,000
  • Operating Expenses: $30,000
  • Net Income: $30,000

Vertical Analysis of Income Statement:

For the income statement, we’ll express each line item as a percentage of Revenue ($150,000):

  • COGS: $90,000 / $150,000 x 100 = 60%
  • Gross Profit: $60,000 / $150,000 x 100 = 40%
  • Operating Expenses: $30,000 / $150,000 x 100 = 20%
  • Net Income: $30,000 / $150,000 x 100 = 20%

Interpretation:

  • Balance Sheet: The vertical analysis tells us that 10% of the company’s assets are financed through accounts payable, 20% through long-term debt, and the remaining 70% through equity (50% common stock + 20% retained earnings).
  • Income Statement: 60% of the revenue is spent on COGS, 20% on operating expenses, and the remaining 20% is net income, which would be available for shareholders or reinvestment.

The vertical analysis allows ABC Corp to easily compare these ratios over time or with other companies, irrespective of their size. It also helps in identifying any trends or changes in these ratios, which can be an indicator of the company’s financial health or effectiveness in managing its resources.

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