Vertical analysis is the comparison of financial statements by representing each line item on the statement as a percentage of another (base) line item.
The objective of vertical analysis is to be able to compare financial statements either from different accounting periods, different businesses or to industry averages by restating the information relative to a common base line item. For this reason vertical analysis is also known as vertical common size analysis or simply common size analysis.
The analysis can be carried out on any of the financial statements but is usually performed on the balance sheet and income statement. While the vertical analysis can be performed on each statement in isolation, it is always better to analyse both balance sheet and income statements together to avoid drawing the wrong conclusions about the performance of a business.
Vertical Analysis Formula
In vertical analysis each line item is calculated as percentage of a common base line item. The vertical analysis formula used to calculate the line item percentages is as follows:
For example, on the income statement, if the base chosen is revenue, then each line item would be expressed as a percentage of revenue. If revenue for the period is 60,000 and sales and marketing expenses are 8,000, then the line item percentage for sales and marketing expenses is given by the vertical analysis formula as follows:
Revenue (Base) = 60,000 Sales and marketing = 8,000 Line item % = Line item amount / Base line item amount Line item % = 8,000 / 60,000 = 13.3%
Vertical Analysis of Income Statement
This example shows a vertical analysis of an income statement with the right hand column showing each line item as a percentage of revenue.
|Cost of sales||24,000||40.0%|
|Research and development||5,000||8.3%|
|Sales and marketing||8,000||13.3%|
|General and administrative||12,000||20.0%|
|Income before tax||8,000||13.3%|
|Income tax expense||1,600||2.7%|
Having carried out the vertical analysis, the next step is to use these common size income statements to make comparisons to the similar statements from different periods, different businesses, or industry averages. This technique is more fully discussed in our common size income statement tutorial.
Vertical Analysis of Balance Sheet
Vertical analysis can also be carried out on the balance sheet statement. Again the process involves choosing a base line item and then expressing each line item in the balance sheet as a percentage of that base item.
In the example below total assets has been chosen as the base line item and the right hand column shows each line item as a percentage of total assets.
|Long term assets||130,000||63.1%|
|Total liabilities and equity||206,000||100.0%|
Again, the next step is to use these vertical analysis common size statements to make comparisons to similar statements from different periods, businesses or industry averages. This technique is more fully discussed in our common size balance sheet tutorial.
Vertical Analysis of Cash Flow Statement
Finally, vertical analysis can also be carried out on the cash flow statement. In the example below revenue (from the income statement) has been chosen as the base line item and the right hand column shows each line item as a percentage of revenue which, for this example, is assumed to be 120,000.
|Add back depreciation||12,000||10.0%|
|Net cash flow||15,000||12.5%|
|Opening cash balance||1,000||0.8%|
|Closing cash balance||16,000||13.3%|
The above vertical financial statement analysis uses revenue as the base line item, however, other appropriate base line items such as total cash inflow could equally well have been used.
Vertical and Horizontal Analysis
Vertical analysis in accounting is only one technique which can be used to analyze financial information. As an alternative, horizontal analysis can be carried out where financial statements and accounting ratios are compared over a number of accounting periods in order to spot trends over time.