Vertical analysis is a type of business analysis that involves a different presentation of the accounting statements to provide new insight. Specifically, under vertical analysis the line items are written as percentages of a major item, rather than levels. This puts them into relative terms instead of absolute terms. There are useful insights that a manager can gain from this examination of the relative sizes of each item, especially when done as a year over year comparison. In this post we will review vertical analysis and explain what it can do for your business and what businesses benefit most from it.
What Is a Vertical Analysis?
Vertical analysis is the practice of taking either the balance sheet or the income statement and presenting each item in percentages. For example, on the income statement you would take each item and write it as a percentage of total sales so that, for example, salaries and wages becomes “25 percent of sales” instead of “$250,000”. For the balance sheet most vertical analyses use the total assets as the denominator, but depending on your goals you can also break that down into percentage of total equity and total liabilities for the relevant categories.
Who Uses Vertical Analyses?
The most common users of vertical analysis are accounting-savvy middle and upper managers who want to see how the company has performed recently and try to build projections for the future. Vertical analysis is also useful for determining how well previous forecasts predicted performance. While a vertical analysis itself is generally not enough to provide a clear insight into the direction of a company, a manager might use it as supporting evidence to make an argument about, for example, whether or not costs have risen too high. They are unlikely to make frequent use of vertical analysis because the best way to use it is across years. Quarters tend to have too much random and seasonal fluctuation to draw conclusions. So a manager might work on a vertical analysis for a year-in-review presentation and fit the results into an overall story of the past year.
How to Create a Vertical Analysis
One of the main draws of a vertical analysis is just how easy it is to perform. All you have to do is start out with the balance sheet or income statement. The one that you should use is the one that will be more insightful for your specific goals. That means, for example, that if you want to talk about a problem with collecting on accounts then you need to focus on the balance sheet, while if you are more concerned with ages the income statement is more important. It is common to do both because it is easy enough to carry out and the results can be interesting.
In any case, for the income statement just divide each item by total sales and multiply the result by 100 percent. That will leave you with a column of percentages. Each value will now be measured relative to sales. For the balance sheet you can either do the same thing with total assets or break it down into liabilities and equity. If you do the latter, you’ll be dividing equity items by total equity and liability items by total liabilities. It is up to you to decide which is more useful. Too much information can be overwhelming, and not enough leaves the other person confused and wanting more clarity. Each case can be built with a simple Excel spreadsheet and a little time.
How a Vertical Analysis Can Help Your Business
Vertical analysis can help you see where a cost rise is coming, especially during a growth phase. When the company is expanding it can be hard to keep numbers in perspective because everything is growing at the same time. Under vertical analysis you can see if, for example, salaries are taking up a larger and larger share of sales or if they are rising without taking up more relative revenue.
Vertical analysis can show when an accounting problem like too many unpaid accounts receivable is becoming significant. Having that category become a large percentage of assets might indicate customers are failing to pay on time or the company’s collection method is too inefficient.
A good vertical analysis can determine how the cost mix of a company compares to the industry averages, especially when the company is larger or smaller than the average for the industry. For example, a startup in an industry probably should not be spending the same percentage of its sales on office supplies as an established firm.
Likewise, vertical analysis can use industry or competitor averages to construct predictive models. If a company one year older saw a gradual increase in wages as a percentage of sales, then it is more likely that your company will experience the same thing unless you decide to take action first.
Vertical analyses are a simple and powerful tool that takes very little in the way or time or resources to create. They fit businesses of any size and stage, but they tend not to be deep enough to demonstrate specific problems on their own. Consider using them anytime you want to get a birds-eye view of a concern, want to build a model for the company in the coming year, or see how the cost mix for the company has evolved over time. Remember that these things change from quarter to quarter based on sometimes-random factors, so do not put too much weight into changes at that frequency.
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