How to Prepare a Vertical Analysis of Financial Statements

Vertical analysis is a financial tool that transforms raw financial data into percentages, providing a clearer view of a company’s financial composition. This method expresses each line item within a single financial statement as a proportion of a chosen base figure. By standardizing financial information, vertical analysis offers insights into how different elements contribute to the overall financial picture.

Identifying Relevant Financial Statements

To conduct a vertical analysis, two primary financial statements are used: the Income Statement and the Balance Sheet. Each statement offers a distinct perspective on a company’s financial standing and operational results. Selecting the appropriate base amount is fundamental for each statement to ensure meaningful analysis.

For the Income Statement, the base amount is total revenue. This choice allows every expense and income item to be expressed as a percentage of the revenue generated, revealing how much of each sales dollar is consumed by various costs or contributes to profit. Total revenue is the top-line figure on an income statement.

The Balance Sheet uses total assets as its base amount. By dividing each asset, liability, and equity item by total assets, the analysis shows the proportional distribution of a company’s resources and how those resources are financed. Total assets is a clearly labeled aggregate figure at the bottom of the asset section.

Performing the Calculations

The process of performing vertical analysis involves applying a consistent formula to each relevant line item on the chosen financial statement. This calculation converts absolute dollar amounts into percentages, facilitating comparative analysis. The universal formula for vertical analysis is: (Line Item Amount / Base Amount) x 100 = Percentage.

To apply this to an Income Statement, each item, such as Cost of Goods Sold or Operating Expenses, is divided by the total revenue for the period. For instance, if a company has $1,000,000 in total revenue and $400,000 in Cost of Goods Sold, the calculation would be ($400,000 / $1,000,000) x 100, resulting in 40%. This indicates that 40 cents of every revenue dollar was spent on the direct costs of producing goods.

Similarly, for the Balance Sheet, each asset, liability, and equity account is divided by the total assets. For example, if total assets are $500,000 and the cash balance is $50,000, the calculation is ($50,000 / $500,000) x 100, yielding 10%. This means that cash represents 10% of the company’s total assets, creating a common-size financial statement where all figures are expressed as percentages.

Understanding the Insights

Once percentages are calculated, vertical analysis provides insights through interpretation. These percentages reveal the internal structure and composition of a company’s financial statements. For example, the percentage of Cost of Goods Sold to total revenue on an Income Statement indicates the direct cost efficiency of sales, while the percentage of accounts receivable to total assets on a Balance Sheet shows how much of a company’s assets are tied up in customer credit.

Analyzing these percentages over several periods for the same company can highlight trends in its financial performance and structure. A rising percentage of operating expenses relative to revenue, for instance, might suggest changes in cost management. Comparing a company’s vertical analysis results to industry benchmarks or competitors provides external context, revealing how its financial proportions stack up against peers.

The insights gained from vertical analysis can inform various financial decisions. A high proportion of long-term debt on the Balance Sheet might suggest a reliance on borrowing for financing, while a consistent percentage of net income on the Income Statement indicates stable profitability. This proportional view helps stakeholders assess a company’s financial health and operational efficiency, regardless of its absolute size.