# Vertical Analysis

Vertical analysis is a type of financial statement analysis where each line item is expressed as a percentage of some base figure. For example, one line item may be listed as a percentage of gross sales, while another is listed as a percentage of total assets.

## Understanding vertical analysis

Vertical analysis is a financial analysis technique used to assess the relative proportions of different line items on a company’s financial statement.

The method involves a comparison between individual line items and a common base such as total assets, liabilities, or revenue. For example, if the chosen base is revenue, then each line item would be expressed as a percentage of revenue.

Percentages are often listed in a separate column in a common-size financial statement like an income statement, balance sheet, or cash flow statement. These commonly form part of horizontal analyses where each item is expressed as a percentage of itself at an earlier point in time.

Vertical analysis is a valuable tool for assessing the financial health of a company and identifying areas where it may be over or under-allocated. When analysts can normalize line items such as net income, they can also easily determine how companies of various sizes manage their assets, liabilities, income, and so forth.

## Vertical analysis example

In this example, letโs take a look at how ABC Corporationโs expenses are impacting its net profit. Below, weโve listed a couple of general income statements over two years with line items, total dollar amounts, and percentages:

### Year 1 โ Total sales: \$750,000 (100%)

• COGS โ \$159,500 (21.3%).
• Gross profit โ \$590,500 (78.7%).
• Staff salaries โ \$223,000 (29.7%).
• Rent โ \$28,000 (3.7%).
• Utilities โ \$36,000 (4.8%).
• Marketing โ \$27,500 (3.7%).
• Total expenses โ \$314,500 (41.9%).
• Net profit โ \$276,000 (36.8%).

### Year 2 โ Total sales: \$900,000 (100%).

• COGS โ \$212,000 (23.5%).
• Gross profit โ \$688,000 (76.5%).
• Staff salaries โ \$290,000 (32.2%).
• Rent โ \$36,000 (4%).
• Utilities โ \$41,000 (4.5%).
• Marketing โ \$55,000 (6.1%).
• Total expenses โ \$422,000 (46.8%).
• Net profit โ \$266,000 (29.5%).

In the above, we can see that while sales increased in the second year, the companyโs gross profit and net profit percentage decreased.

While one could reasonably assume that the increase in COGS correlates with increased sales, the vertical analysis shows that costs did not increase at a rate that was proportional this increase.

The business may choose to reduce its COGS to increase gross profit. Alternatively, an investor may look at why salary and marketing costs increased substantially in the second year to determine whether the company is a sound long-term investment.

## Limitations to vertical analysis

Vertical analysis provides a clear picture of the relative size or importance of items in a financial statement and can be used to identify trends or compare different companies.

But there do exist some limitations to the technique:

1. No absolutes โ a vertical analysis does not consider the impact of changes in the absolute amounts of a base item such as inflation or fluctuation in the value of a currency. It also does not provide an accurate indication of absolute performance. For example, an increase in COGS as a proportion of total sales may indicate an increase in sales volume or poor cost control.
2. Limited scope โ by extension, these analyses are also limited in their ability to provide a complete understanding of a financial statement. This is because they only evaluate the relationship between each item and a single base item.
3. Bias โ the choice of base item can significantly affect the results of the analysis. Whatโs more, a vertical analysis does not take into account external factors such as changes in the market or economic conditions.

## Key takeaways:

• Vertical analysis is a type of financial statement analysis where each line item is expressed as a percentage of some base figure. For example, one line item may be listed as a percentage of gross sales, while another is listed as a percentage of total assets.
• The method involves a comparison between individual line items and a common base such as total assets, liabilities, or revenue. For example, if the chosen base is revenue, then each line item would be expressed as a percentage of revenue.
• Vertical analysis provides a clear picture of the relative size or importance of items in a financial statement and is used to identify trends or compare different companies. But the method does have limited scope, can be biased, and does not deal in absolutes.

## Connected Economic Concepts

Market Economy

Positive and Normative Economics

Inflation

Asymmetric Information

Autarky

Demand-Side Economics

Supply-Side Economics

Creative Destruction

Happiness Economics

Oligopsony

Animal Spirits

State Capitalism

Boom And Bust Cycle

Circular Flow Model

Market Types

Rational Choice Theory

Conflict Theory

Peer-to-Peer Economy

Knowledge-Economy

Command Economy

Labor Unions

Bottom of The Pyramid

Glocalization

Market Fragmentation

L-Shaped Recovery

Economies of Scale

Diseconomies of Scale

Economies of Scope

Price Sensitivity

Network Effects

Negative Network Effects

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