Vertical Analysis Is Also Called - Analysis

Vertical Analysis: Also Called Common-Size Analysis – A Deep Dive

Vertical analysis, also known as common-size analysis, is a powerful financial statement analysis technique that expresses each line item of a financial statement as a percentage of a base figure within the same statement. This allows for a clear comparison of financial performance over time, or against industry benchmarks, even when the absolute figures vary significantly due to company size or growth. Understanding vertical analysis is crucial for investors, creditors, and business owners alike to assess financial health and identify trends. This article will provide a comprehensive understanding of vertical analysis, including its applications, benefits, limitations, and practical examples.

What is Vertical Analysis? A Detailed Explanation

Vertical analysis simplifies complex financial data by normalizing it. Instead of looking at raw numbers, which can be misleading when comparing companies of different sizes, vertical analysis focuses on the proportions of different accounts. This allows for a more meaningful comparison and a better understanding of a company's financial structure and performance.

How it Works:

The process involves selecting a base figure for each financial statement. Then, each line item is divided by that base figure and multiplied by 100 to express it as a percentage.

• Income Statement: The base figure is usually net sales or revenue. Each item (cost of goods sold, gross profit, operating expenses, etc.) is expressed as a percentage of net sales. This reveals the proportion of each cost relative to revenue, offering insights into profitability and efficiency.

• Balance Sheet: The base figure is usually total assets. Each asset and liability is expressed as a percentage of total assets. This showcases the proportion of various assets and how they are financed (through liabilities and equity). Alternatively, total liabilities and equity can also serve as the base for comparative analysis.

Why Use Vertical Analysis? Unveiling its Advantages

Vertical analysis offers several significant advantages over analyzing raw financial data alone:

• Comparative Analysis: It allows for easy comparison of financial statements across different periods for the same company, highlighting trends and changes in financial structure over time. This is especially useful for identifying potential problems or successes in specific areas of the business.

• Benchmarking: It facilitates comparison of a company's financial performance with industry averages or competitors. This provides valuable context, indicating whether the company is performing well or poorly relative to its peers. Identifying outliers – both positive and negative – can highlight areas requiring attention.

• Identifying Trends: By comparing percentages over several years, analysts can spot emerging trends, such as increasing reliance on debt financing or a shrinking profit margin. Early identification of these trends allows for proactive management interventions.

• Revealing Financial Health: The analysis unveils the company's financial health by highlighting potential problems, such as excessively high operating expenses or a declining gross profit margin. It allows for a comprehensive picture of the company's efficiency and profitability.

• Simplicity and Clarity: By expressing data as percentages, vertical analysis simplifies complex financial information, making it easier to understand and interpret, even for individuals without extensive accounting expertise. This accessibility is crucial for effective communication with stakeholders.

Common-Size Statements: The Heart of Vertical Analysis

The output of vertical analysis is often presented in common-size statements. These statements display the financial data as percentages, making it easier to spot trends and comparisons. Common-size statements provide a standardized view, removing the scale distortion that can occur when comparing companies with varying sizes.

Vertical Analysis: Income Statement Example

Let's illustrate vertical analysis with a simplified income statement example:

Company A – Income Statement (Year 1)

This common-size income statement reveals that Company A's cost of goods sold is 60% of net sales, leaving a gross profit margin of 40%. Operating expenses consume 25% of net sales, resulting in a 15% operating income margin. This detailed breakdown highlights profitability ratios, allowing for comparisons with past periods or industry benchmarks.

Vertical Analysis: Balance Sheet Example

Now let's apply vertical analysis to a simplified balance sheet:

Company A – Balance Sheet (Year 1)

This common-size balance sheet demonstrates that Company A's assets are primarily composed of property, plant, and equipment (40%), followed by inventory (30%). The company's financing is predominantly equity (60%), indicating a relatively low reliance on debt.

Limitations of Vertical Analysis

While vertical analysis offers many benefits, it's crucial to acknowledge its limitations:

• Oversimplification: It presents a simplified view of complex financial situations. It doesn't capture the nuances of business operations or external factors.

• Lack of Absolute Values: The focus on percentages can obscure the absolute size of the company and the actual monetary values involved. A small percentage change in a large number is still significant in absolute terms.

• Industry-Specific Considerations: Direct comparison between companies across different industries might be inappropriate without considering industry-specific benchmarks and differences in accounting practices.

• Potential for Manipulation: While rare, companies might use accounting techniques to artificially improve their common-size ratios, misleading investors.

Interpreting the Results: Key Insights

The most important aspect of vertical analysis is interpreting the results. This requires a thorough understanding of the company's industry, business model, and overall economic conditions. Analyzing trends over multiple periods is essential to draw meaningful conclusions.

Combining Vertical Analysis with Other Techniques

Vertical analysis is most effective when used in conjunction with other financial statement analysis techniques, such as:

• Horizontal Analysis: This compares financial statements over time, showing the change in absolute values. Combining horizontal and vertical analysis provides a comprehensive picture of both the magnitude and proportion of changes.

• Ratio Analysis: This uses key ratios derived from financial statements to assess various aspects of a company's performance, such as liquidity, profitability, and solvency. Vertical analysis can provide context for interpreting these ratios.

Conclusion: Mastering Vertical Analysis for Sound Financial Decisions

Vertical analysis, or common-size analysis, is an invaluable tool for analyzing financial statements. Its ability to normalize financial data, facilitating comparisons across time and among companies, makes it an indispensable part of any comprehensive financial analysis. By understanding its applications, limitations, and interpretation, both novice and experienced financial analysts can extract meaningful insights and make better-informed decisions. Remember to use vertical analysis in conjunction with other techniques for a complete and accurate assessment of a company's financial health. The ability to confidently analyze common-size statements allows for the effective evaluation of business performance, ultimately leading to sound financial decisions.