Vertical analysis: what it is and how to calculate it

Financial analysis is the process of assessing a company's finances. It helps traders and investors make informed decisions. One of its primary methods is vertical analysis, which breaks down financial data to identify trends and find insights. This process plays an integral part in strategic planning.

What is vertical analysis?

Vertical analysis, also known as structural analysis, is a method of analysing financial statements by expressing each line item as a percentage of a baseline figure.

For example, in the income statement, each line item is shown as a percentage of revenue. This allows us to determine which cost or revenue item has the biggest impact on the overall financial performance.

Vertical analysis formula

To perform a vertical analysis, divide the value of a specific item by the total value of a key reference figure —total assets for a balance sheet or total sales for an income statement—then multiply by 100% to express it as a percentage.

The formula for calculating the structural analysis percentage:

Vertical analysis formula

$$\mathrm{Vertical\; analysis\; formula}\left(\mathrm{Income\; statement}\right)=\frac{\text{Income Statement Item}}{\text{total Sales}}\times \mathrm{100\%}$$

$$\mathrm{Vertical\; analysis\; formula}\left(\mathrm{Balance\; Sheet}\right)=\frac{\text{Balance Sheet}}{\text{total Assets (Liabilities)}}\times \mathrm{100\%}$$

When we convert data into percentages, we gain a clearer view of the proportion of the company's overall financial assets and liabilities.

Vertical analysis example

Let's take a company with the following balance sheet data as of December 31st, 2022:

The company's total assets:

$$\mathrm{Cash}+\mathrm{accounts\; receivable}+\mathrm{fixed\; assets}$$

$$\mathrm{\$100,000}+\mathrm{\$40,000}+\mathrm{\$50,000}$$

$$=\mathrm{\$190,000}$$

Using the vertical analysis formula,

$$\mathrm{cash}:\frac{\$\mathrm{100,000}}{\$\mathrm{190,000}}\times 100=52.63\%$$

$$\mathrm{accounts\; receivable}:\frac{\$\mathrm{40,000}}{\$\mathrm{190,000}}\times 100=21.05\%$$

$$\mathrm{Notes\; payable}:\frac{\$\mathrm{10,000}}{\$\mathrm{190,000}}\times 100=5.26\%$$

The above process can be formulated for the remaining items in the company balance sheet data.

In the table above, each line item is computed in reference to the baseline Item. For instance, the line item 3 is computed as follows:

$$\mathrm{line\; item\; 3}:\frac{\mathrm{19,800}}{\mathrm{90,000}}=22\%$$

Why is vertical analysis important?

Vertical analysis makes comparing financial statements across different companies and industries easy. It helps track changes over time, giving a clearer picture of a business’s economic health.

For example, by looking at how expense items affect a company's profits, we can measure how efficiently this company manages costs compared to competitors. Imagine company X has revenue of $1,000,000 and cost of sales of $600,000. A vertical analysis will show that the cost of sales is 60% of income.

$$\mathrm{Horizontal\; analysis}:\frac{\mathrm{600,000}}{\mathrm{1,000,000}}\times 100=60\%$$

The above implies that for every dollar of revenue, the business spends 60 cents on goods or services. Suppose we compare these data with those of other companies in the industry, and the results indicate that X has a higher structural value—we can conclude that company X is competitive.

Difference between horizontal and vertical analysis

Horizontal analysis, also known as trend analysis, compares financial data across multiple periods to identify trends and changes in a company’s performance. This method helps assess how key financial indicators evolve over time and forecast future trends.

Horizontal analysis formula

$$\mathrm{Horizontal\; analysis\; formula}(\mathrm{Absolute}=\mathrm{Amount\; in\; comparison\; Year}-\mathrm{Amount\; in\; Base\; Year}$$

$$\mathrm{Horizontal\; analysis}(\%)=\frac{\mathrm{Amount\; in\; comparison\; Year}}{\mathrm{Amount\; in\; Base\; Year}}\times 100$$

Suppose company Y has revenue of $1,000,000 for 2020 and $1,200,000 for 2021.

$(\mathrm{1,200,000}-\mathrm{1,000,000})\times 100=20\%$

This shows a 20% revenue increase over the year. This could indicate an increased demand for the company's products or a successful marketing strategy. Analysing such data over several years allows us to identify long-term trends and draw conclusions about the business's future.

Advantages of horizontal analysis:

• Trend identification. Helps investors identify long-term trends in a company's financial performance. It can be useful for strategic planning and management decision-making.
• Dynamics analysis. It allows us to assess how a company's financial performance changes over time. This can help identify the business's strengths and weaknesses and select areas for improvement.
• Prediction. Based on the identified trends, traders can make predictions for the future. This is useful for budget planning, evaluating investment projects, and making other strategic decisions.

Now let's look at how vertical analysis differs from horizontal analysis:

• Approach to analysis. Focuses on the structure of a single reporting period, while horizontal analysis compares data from multiple periods. This makes each method unique and helpful in different situations.
• Purpose of the analysis. Allows investors to understand the structure of costs and revenues, while horizontal analysis helps to identify trends and changes. Both methods complement each other and provide a more complete picture of a company's financial health.
• Application. Useful for comparing companies of different sizes, while horizontal analysis is more suitable for assessing the dynamics of a single company. This makes them helpful tools for different types of analyses and decision-making.

Pros and cons of vertical analysis

Like any other method, vertical analysis has advantages and disadvantages. Let's examine them in detail.

Advantages:

• Makes it easy to compare the financial statements of different companies, regardless of their size. This is especially useful for investors and analysts who want to evaluate the performance of other enterprises in the same industry.
• Helps one understand which cost items account for the largest share of the overall cost structure. This information is essential for identifying areas where costs can be reduced or efficiency improved.
• Shows the company's cost and revenue structure changes over time. This data allows one to identify trends and determine how the company's financial health is changing.

Disadvantages:

• Vertical analysis assumes that costs and revenues always remain the same. However, this is not always the case. Therefore, this analysis is not always reliable for companies with changing funds.
• Although vertical analysis simplifies information, it does not consider reasons for the relationship between expenses and revenues. For example, if you only look at the cost of production, you won't see how much effort was put into developing the product.

How to perform vertical analysis

Vertical balance sheet analysis is a way to learn more about your company's financial health. It is calculated by dividing each balance sheet item by total assets and finding the percentage. This will tell you the percentage of total assets each item takes up.

To do a structural analysis, you need to:

1. Gather the balance sheet data for each line item.
2. Determine the total amount of assets.
3. Divide each balance sheet item by total assets and multiply by 100.
4. Analyse the results and find patterns.
5. Compare the results with those of other companies in your industry.
6. Use the information to make decisions.

Final thoughts

• Vertical analysis is a quick and simple calculation that can be performed to obtain financial information.
• It allows you to compare the company's performance with other businesses in the same industry and decide on an investment strategy.
• To perform it, divide each balance sheet item by total assets and multiply the number by 100.
• Structural and horizontal analyses compare different things and are more effective when done together.