Vertical analysis is an accounting tool that enables proportional analysis of documents, such as financial statements. While performing a vertical analysis, every line item on a financial statement is entered as a percentage of another item. For example, on an income statement, every line item is stated in terms of the percentage of gross sales.
Similarly, in a balance sheet, every entry is made not in terms of absolute currency but as a percentage of the total assets. Performing a vertical analysis of a company’s cash flow statement represents every cash outflow or inflow relative to its total cash inflows.
When is Vertical Analysis Used?
Vertical analysis is most commonly used within a financial statement for a single reporting period, e.g., quarterly. It is done so that accountants can ascertain the relative proportions of the balances of each account.
Vertical analysis is exceptionally useful while charting a regression analysis or a ratio trend analysis. It enables the accountant to see relative changes in company accounts over a given period of time. The analysis is especially convenient to do so on a comparative basis.
Advantages of Vertical Analysis
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, management may consider shutting down a particular unit if profit per unit falls below a particular threshold percentage.
It is a relatively more potent tool than horizontal analysis, which shows the corresponding changes in the finances of a particular unit/ account/department over a certain period of time.
It is also useful in comparing a company’s financial statement to the average trends in the industry. It would be ineffective to use actual dollar amounts while analyzing entire industries. Common-size percentages solve such a problem and facilitate industry comparison.
It is also highly effective while comparing two or more companies operating in the same industry but with different sizes. It is often tricky to compare the balance sheet of a $1 billion company to one that is valued at $500,000. Vertical analysis enables accountants to create common-size measures, which enable them to compare and contrast amounts of different magnitudes in a very efficient manner.
1. Comparative Balance Sheet with Vertical Analysis