Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.
In this lesson, we'll define vertical analysis. You'll learn about the most widely used financial statements to complete the analysis. We'll also discuss how to calculate vertical analysis and interpret the results.
What Is Vertical Analysis?
Jamie is a college student at the University of Analytics. She is in the top ten percent of her class and has been chosen to work for the largest accounting firm in the state as a summer intern.
On her first day, the manager of financial analysis asks all the summer interns to attend a short seminar. The manager starts the seminar by asking, 'What is vertical analysis?' Someone in the back raises their hand and says they haven't covered this section in class yet. The manager looks puzzled; she thought these interns were well versed in the area of financial analysis.
Nevertheless, she goes on to say that vertical analysis compares other line items of the same financial statement against revenue on the income statement or assets on the balance sheet. Vertical analysis is also called common-size analysis and allows investors, bankers and other users to easily compare how well a company is performing against revenue or assets.
The manager reassures the interns that they will be able to grasp this analytical process pretty easily even if their professor has not presented the information. For the rest of the lesson, we'll explore the components of the most commonly used financial statements for vertical analysis: the balance sheet and income statement. You'll also learn how to complete a vertical analysis using both financial statements and interpret the results.
The manager starts her presentation by explaining the balance sheet. Remember, the balance sheet shows the worth of the company and includes three main categories: assets, liabilities and equity. Assets are items that are owned, such as a building. Liabilities are obligations that are owed, such as a mortgage loan. Lastly, equity represents the investment in the company.
To complete a balance sheet vertical analysis, you take the comparing line item / base line item. Let's look at assets as they relate to liabilities.
Assets in year one will be our base. Our base will always have a percentage of 100. We are comparing liabilities to assets; therefore, liabilities are our comparing line item. Now, let's calculate the vertical analysis by taking liabilities / assets.
$5,001,000 / $14,501,000 = 34%
Therefore, we can say that liabilities are 34% of assets.
The same calculation is performed for year two: liabilities / assets.
$3,700,000 / $17,512,000 = 21%
Now we're able to compare year two to year one. We were able to decrease our liabilities as a percentage of assets by 13%.
After the calculation, you should go one step further to analyze why liabilities decreased as a percentage of assets even though the results were positive. For example, some questions to ask are, did we pay off a building or a truck loan?
Back in our presentation, the manager asks if there are any questions. We all say no, so she decides it's time to move on to the income statement.
The income statement shows profit. The main categories of the income statement are revenue and expenses. Revenue, of course, are sales, and expenses are the cost of running the business, such as utilities or a truck payment.
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An income statement vertical analysis is very similar to the balance sheet vertical analysis, except we're using revenue as our base.
We are comparing expenses to revenue, therefore, expenses is our comparing line item. Now let's calculate the vertical analysis by taking expenses / sales revenue.
$15,153,000 / $21,415,000 = 71%
Therefore, we can say expenses are 71% of revenue.
The same calculation is performed for year two again, expenses / sales revenue:
$18,123,000 / $20,141,000 = 90%
Now we're able to compare year two to year one by noting our expenses rose by 19% over revenue. Again, why? Are we baking a significantly higher number of pies, which increases our electricity bill? Did we purchase more semi-trucks, which increases our monthly truck payments? These are some of the questions you can ask to help analyze the results.
The manager asks again if there are any questions, but no one raises their hands, and everyone looks confident. Now it's time to return to our desks to find our first project on vertical analysis.
Vertical analysis compares other line items of the same financial statement against revenue on the income statement or assets on the balance sheet. Vertical analysis is also called common-size analysis, and shows investors, bankers and other users to easily compare how well a company is performing against revenue or assets.
When completing a vertical analysis, you will use revenue or assets as a base. Then take the line item you are comparing and divide it into the base. Remember, interpreting the results are just as important as calculating the numbers.
Vertical analysis: also called common-size analysis, allows easy comparison of how well a company is performing against revenue or assets
comparing line item / base line item
The base line item is revenue or assets
Balance sheet: shows the worth of the company and includes assets, liabilities, and equity
Assets: items that are owned
Liabilities: obligations that are owed
Equity: the investment in the company
Income statement: shows profit and includes revenue and expenses
After reviewing this lesson, you should be able to:
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