What is vertical analysis of financial statements?

Analyzing financial statements vertically, often referred to as vertical analysis or common-size analysis, is a comparative approach that helps assess the composition and relative proportion of individual line items within a financial statement. This analysis expresses each line item as a percentage of a base item, typically total revenue or total assets, allowing for a more detailed understanding of a company's financial structure. Here's how to perform vertical analysis:

1. Select the Base Item:

• Choose a base item for the analysis. Common choices include total revenue for the income statement and total assets for the balance sheet. The base item provides a reference point against which other line items are expressed as percentages.

2. Calculate the Percentages:

• For each line item in the financial statement, divide its value by the value of the base item and multiply by 100 to express it as a percentage. This calculation standardizes all line items, making them comparable.

3. Examine the Income Statement:

• For the income statement, each line item is expressed as a percentage of total revenue. This reveals the proportion of revenue allocated to different expenses and the resulting net profit margin. It helps identify cost structures, operating efficiencies, and the impact of specific expense categories on overall profitability.

Example:

• Gross Profit Margin = (Gross Profit / Total Revenue) x 100
• Operating Profit Margin = (Operating Profit / Total Revenue) x 100
• Net Profit Margin = (Net Profit / Total Revenue) x 100

4. Analyze the Balance Sheet:

• For the balance sheet, each line item is expressed as a percentage of total assets. This analysis provides insights into the composition of assets, liabilities, and equity, as well as the relative proportions of various components. It helps identify how a company's assets are financed and the degree of leverage.

Example:

• Current Assets as a % of Total Assets = (Current Assets / Total Assets) x 100
• Total Liabilities as a % of Total Assets = (Total Liabilities / Total Assets) x 100
• Equity as a % of Total Assets = (Equity / Total Assets) x 100

5. Interpret the Results:

• Vertical analysis highlights trends, patterns, and potential areas of concern or opportunity. It allows for a detailed comparison of financial statements over time, across companies, or within the same industry. Look for significant changes in the composition of line items or any disproportionate increases or decreases.

6. Industry Benchmarking:

• Compare the results of vertical analysis to industry benchmarks and peer companies. Differences may indicate competitive advantages or areas that require improvement. It can also help assess whether a company's financial structure aligns with industry norms.

7. Qualitative Assessment:

• Combine the insights from vertical analysis with qualitative information, such as industry dynamics, market conditions, and company-specific factors, to gain a comprehensive understanding of the company's financial health and performance.

Vertical analysis is a valuable tool for financial statement analysis because it standardizes line items and allows for meaningful comparisons over time and across companies. It complements horizontal analysis (comparative analysis of line items over multiple periods) and ratio analysis to provide a well-rounded view of a company's financial position and performance.