Vertical analysis (or common-size analysis) and horizontal analysis (also known as trend analysis) are two of the most commonly used tools in financial statement analysis. This helps to determine whether a company’s performance has been improving or declining over time due to various factors, such as competitive pressure and new product launches. By using both vertical and horizontal analyses, businesses can gain a better understanding of their financial position and performance.
- In the 3rd year, the COGS decreased compared to the previous years, and the income increased.
- However, it has certain limitations that should be taken into account when relying on its output.
- From the table above, we calculate that cash represents 14.5% of total assets while inventory represents 12%.
- Let us understand the advantages of vertical analysis equation through the points below.
It categorizes cash flows into operating activities, investing activities, and financing activities. The cash flow statement is vital in assessing a company’s ability to generate cash and its cash management practices. You can compare companies in the same industry by standard comparisons of key line items. By comparing other companies’ percentages against your own, you can understand the strengths, weaknesses, and changes you will need to make.
Example of the Vertical Analysis Formula
This is done by portraying financial data in the form of percentages rather than absolute values. This makes it possible to assess companies with varying levels of sales or assets on a level playing field. Consequently, analysts can normalize items such as total income and net income across businesses of varying sizes. This reveals how these enterprises manage their assets, liabilities, income, expenses, and cash flow, despite of their overall scale. It enables analysts to identify trends, patterns, and anomalies within a company’s financial statements.
By Industry
Horizontal analysis indicates long-term trends and highlights areas of strength and those that need improvement. Vertical analysis indicates the relative importance of each line item in a certain period. We must also consider that there may be another factor responsible for the significant rise in total sales in year 3 – such as a robust economy driving significantly higher sales in this year. This may be due to higher demand or some other factor that needs to be investigated. It’s important to keep these limitations in mind and utilize complementary analysis methods to enhance the accuracy and depth of your financial assessments.
SaaS Profit and Loss Statement
This method expresses each line item on vertical analysis is also known as a financial statement as a percentage of a key benchmark, typically total revenue (in the case of the income statement) or total assets (for the balance sheet). It allows stakeholders, including investors, analysts, and management, to gain valuable insights into a company’s financial structure and performance. In vertical analysis, each line item in the financial statement is expressed as a percentage of a base figure in the same period (for example, the total assets or gross sales). However, in horizontal analysis, the relative change in a line item from one period to the next is calculated and typically presented as a percentage change.
To increase the effectiveness of vertical analysis, multiple year’s statements or reports can be compared, and comparative analysis of statements can be done. This analysis makes it easier to compare the financial statements of one company with another and across the companies as one can see the relative proportion of accounts. This technique fosters informed decision-making and strategic planning, vital for sustained success in today’s competitive financial landscape. At the same time, it helps with managing expenses and assessing the efficiency of assets, liabilities, and cash source utilization. If year 1, 2, and 3 variable expenses were $150, $148, and $145, the ratios for years 1, 2, and 3 to year one would be 100%, 99%, and 97%. One of the pros of vertical analysis is that it allows for the comparison of financial statements from one accounting period to the next as well as for comparisons among different companies.
Vertical analysis helps investors assess the financial health and stability of a company, compare companies within an industry, and identify potential risks and opportunities. Interpreting the results of vertical analysis involves assessing the significance of changes in line item percentages over time or in comparison to industry benchmarks. A significant increase or decrease in a particular line item percentage may indicate strengths or weaknesses in a company’s financial position. For instance, a vertical analysis of an income statement might reveal that a company is spending a higher percentage of its revenue on marketing expenses compared to its competitors.
Limitations of Vertical Financial Statement Analysis
Analysts often require a longitudinal assessment of a business’s performance, known as horizontal analysis or trend analysis. Horizontal analysis changes over time in various financial statement elements, such as revenue and expenses. However, vertical analysis shows each financial statement item as a percentage of its earlier period value. Common size analysis is used to calculate net profit margin, as well as gross and operating margins.