Vertical analysis is a fundamental tool in financial statement analysis, allowing accountants, analysts, and business owners to quickly assess the relative size of various accounts and spot trends or anomalies in a company’s financial health. In this blog post, we’ll explain the vertical analysis formula, provide practical steps to perform vertical analysis, and discuss how this powerful tool can enhance your understanding of your organization’s finances.
What is the Vertical Analysis Formula?
Vertical analysis, sometimes called "common-size analysis," compares each item on a financial statement to a base figure within the same period. This method expresses every item as a percentage of the base figure, making it easier to compare accounts and spot patterns within or across periods, regardless of the company’s size.
The vertical analysis formula looks like this:
Percentage of Item = (Specific Item Amount / Base Amount) x 100
On an income statement, the base amount is usually total sales or revenue. On a balance sheet, the base amount is typically total assets or total liabilities and equity.
How to Calculate Vertical Analysis Step by Step
Let’s break down the process for using the vertical analysis formula:
- Choose the Financial Statement: Decide if you’re analyzing the income statement, balance sheet, or another report.
- Select the Base Amount: For income statements, use total revenue or sales. For balance sheets, use total assets or total liabilities and equity.
- Apply the Formula: For each line item, divide its value by the base amount and multiply by 100 to get the percentage.
For example, if your company’s revenue is $200,000 and the cost of goods sold (COGS) is $120,000, COGS as a percentage of revenue would be:
COGS Percentage = ($120,000 / $200,000) x 100 = 60%
This means that 60% of your revenue is going toward COGS—a valuable insight for cost control and profitability analysis.
Benefits of the Vertical Analysis Formula
Using the vertical analysis formula provides several advantages:
- It enables easy comparison between current and prior years, even if total figures have changed dramatically.
- It helps in benchmarking internal results against industry standards.
- It allows for quick identification of significant changes or unusual relationships between accounts.
- It simplifies the presentation of financial statements for non-specialists, since percentages are often easier to interpret than raw numbers.
Limitations to Consider
While the vertical analysis formula is incredibly useful, it isn’t without limitations. External factors like inflation, seasonal business cycles, or significant changes in a company’s operational structure may affect the validity of comparisons over time. Additionally, the formula alone doesn’t explain why a certain trend appears—deeper analysis is often required to get to the root cause.
Conclusion: Make the Most of Vertical Analysis
The vertical analysis formula is a simple yet powerful way to analyze financial statements and reveal valuable patterns in your business’s operations. By expressing each line item as a percentage of a base figure, you gain clarity that is often lost in dollar-based analysis. Remember to complement vertical analysis with other tools and always consider the wider context behind the numbers.