Viewing raw data in financial statements can be relatively pointless without some yardstick against which to compare the numbers. Vertical analysis solves this problem by linking all items in the financial report to one item, forming a so-called common size financial statement.
Vertical analysis of financial reports, by definition, is a comparative analysis that examines the selected indicator as a percentage of the base indicator within the same reporting period. This means that all elements of the report for a certain period are divided by this element. The items that are most commonly used as the baseline by which other items are divided are total assets and revenue. Essentially, vertical analysis creates a ratio between each item and the baseline item.
This transformation of financial statements simplifies the comparison of financial information about a company for different reporting periods, and also allows to compare it with similar financial information about other companies. In addition, the use of vertical analysis allows to identify trends that are not always obvious when analyzing financial statements in a traditional presentation.
Vertical analysis is done within a single reporting period. The vertical analysis allows you to determine the structure of the main elements of assets and liabilities of the organization, the influence of individual factors on the financial result, liquidity indicators.
For calculations, you can use the universal formula:
(Statement line item / Total base figure) X 100
During analysis of the Balance sheet, the total for Assets as well as the total of both Equity and Liabilities are selected as the base values. Consequently, all individual positions in the Assets section are presented as a percentage of its total. Similar calculations are carried out for the Equity and Liabilities section.
In Profit and loss statement’s vertical analysis, Sales revenue generally serves as the base value. All other items in this report (COGS, Operating costs, Interest expense, Wages, Utilities) are calculated as a percentage of it.
When analyzing Cash flows statement, the amount of total cash inflows is used as the base value. This makes it possible to get an idea attraction and repayment of loans and borrowings and other elements. By presenting these items in relative terms, it is possible to assess the extent to which they affect the generation of sales revenue.
The key advantage of this analysis method is an ability to see major or sudden changes in a company’s financial reports. The rapid growth or decline of individual indicators in financial statements will be easily tracked in dynamics.
Also, this technique allows you to get an idea of the various strategies that the company implements. For example, one company may sacrifice profitability in order to increase its market share. This will generally lead to an increase in sales revenue, but will negatively impact gross, operating, and net income. However, such a company will demonstrate higher growth rates.
In conclusion, we can say that vertical analysis is an effective method for determining actual changes in the financial condition of the enterprise. However, to increase effectiveness, it should be used in conjunction with horizontal analysis to help better understand these changes. Vertical analysis is suitable for all forms of enterprise financial statements.