Vertical Analysis of Balance Sheets and Financial Statements

The income from selling the products or services will show up in operating profit. If it is declining, which is in the case of XYZ, Inc., there is less money for the shareholders and for any other goals that the firm’s management wants to achieve. It is also watched closely by lenders (e.g., banks) when assessing a company’s credit risk. The following example shows ABC Company’s income statement over a three-year period. If your vertical analysis reveals unusual trends or variances, take the time to investigate these changes. When using horizontal analysis, balance sheet totals for two periods are required.

Also known as common-size analysis, vertical analysis can help analyze company performance, but it is also a useful tool for comparing the financial statements of two companies. Vertical analysis can also be used to spot trends over a specific period of time. Vertical analysis shows a comparison of a line item within a statement to another line item within that same statement. For example, a business may compare cash to total assets in the current year.

The Comparative Income Statement

Third, it can help highlight areas where a company may be overexposed to risk. This information can be used to revised budgeted funding levels in future periods. Depending on which accounting period an analyst starts from and how many accounting periods are chosen, the current period can be made to appear unusually good or bad. For example, the current period’s profits may appear excellent when only compared with those of the previous quarter but are actually quite poor if compared to the results for the same quarter in the preceding year.

For example, accounting processes such as allocation of common costs and elimination of inter-segment sales can be challenging. The statement of income can be segmented, https://simple-accounting.org/ or disaggregated, to enhance performance analysis. The statement can be segmented in various ways such as by geography or by type of product or service.

Horizontal vs. Vertical Analysis

By looking at the balance sheet, you can see that the majority of your company’s assets are current, with only 25% of assets considered fixed, or long-term assets. First, a direction comparison simply looks at the results from one period and comparing it to another. For example, the total company-wide revenue last quarter might https://simple-accounting.org/a-beginner-s-guide-to-vertical-analysis-in-2021/ have been $75 million, while the total company-wide revenue this quarter might be $85 million. This type of comparison is most often used to spot high-level, easily identifiable differences. Use the three stock ratios to determine whether the common stock has increased or decreased in attractiveness during the past year.

• When using horizontal analysis, balance sheet totals for two periods are required.
• This type of comparison is most often used to spot high-level, easily identifiable differences.
• If you’re preparing the balance sheet manually, be sure that your asset totals balance with your liability and equity totals.
• Once you have chosen the base figure, calculate the percentage that each line item represents of the base figure.
• As an example, in year one we’ll divide the company’s “Salaries” expense, $95,000 by its sales for that year, $400,000.
• There are advantages and disadvantages to everything, including using vertical analysis.

The second column is the common-size version with a vertical analysis based on total assets. Each common-size line item is the percent of total assets that the line item’s dollar value represents. Similarly, vertical analysis of an income statement would show the percentage of total revenue that each expense category represents. This could be useful in identifying areas where a company may be able to cut costs without affecting its overall bottom line too much. The advantage of using vertical analysis is that it makes it easier to compare financial statements from different periods of time or from different companies. Horizontal analysis typically shows the changes from the base period in dollar and percentage.

Other uses and benefits of a vertical analysis

Your strategy is to invest in companies with low price/earnings ratios but in good financial shape. Assume that you have analyzed all other factors and that your decision depends on the results of ratio analysis. The College Shop was doing fine in year 1 (relative to the industry), but something happened in year 2 to break your stride.

If your analysis reveals unusual trends or variances, take the time to investigate these changes. For example, a significant increase in your accounts receivable balance and a noticeable decrease in cash can signal difficulty in collecting payments from your customers. If this continues over several months, revisiting credit practices or collection methods may be in order. Remember, on a balance sheet, your base number is always your total assets and total liabilities, and equity. For example, if Mistborn Trading set total assets as the base amount and wanted to see what percentage of total assets were made up of cash in the current year, the following calculation would occur.

This figure means that companies in the industry have, on average, $14.50 in operating income to cover each $1.00 of interest that it must pay. In ABC Company’s case, we can clearly see that costs are a big reason profits are declining despite the company’s robust sales growth. What we don’t know, and what we can’t know from the vertical analysis, is why that is happening. The vertical analysis raises these questions, but it cannot give us the answers.

If there are any fixed assets that can be sold, management should consider selling them to lower both the depreciation and interest expense on debt. This should help the company’s common size income statement in Year 3. Vertical analysis, also known as common-size analysis, is used to evaluate a firm’s financial statement data within an accounting period. This tool uses one line item on the statement as a base against which to evaluate all other items in the same statement.

Management Efficiency Ratios

Let’s fast-forward again and assume that your business—The College Shop—has just completed its second year of operations. After creating your second-year income statement, you decide to compare the numbers from this statement with those from your first statement. So you prepare the comparative income statementFinancial statement showing income for more than one year. In Figure 12.19 “Comparative Income Statement for The College Shop”, which shows income figures for year 2 and year 1 (accountants generally put numbers for the most recent year in the inside column).

• If the company had an expected cash balance of 40% of total assets, they would be exceeding expectations.
• If, on the other hand, you land a great job and your income is 15 times the amount of your interest payments, you can cover them much more comfortably.
• The statement of income can be segmented, or disaggregated, to enhance performance analysis.
• This could be useful in identifying areas where a company may be able to cut costs without affecting its overall bottom line too much.
• Ratio analysis is used to evaluate various aspects of a company’s financial performance such as its efficiency, liquidity, profitability, and solvency.

Horizontal analysis is most useful when an entity has been established, has strong record-keeping capabilities, and has traceable bits of historical information that can be dug into for more information as needed. This type of analysis is more specific relevant for analyzing the value we maybe selling or acquiring. A horizontal analysis is performed by following the three primary steps.