How to Use Vertical Analysis for Financial Statement Comparison in Assignments

Moreover, vertical analysis simplifies complex financial data, making it more accessible and easier to understand. This is particularly helpful for students who may be overwhelmed by the sheer volume of numbers in a financial statement. By focusing on the relative size of each financial element, you can better grasp how different components contribute to the overall financial picture. Also, for student who think how to do my accounting assignment this blog will be useful.

What is Vertical Analysis?

Vertical analysis, also known as common-size analysis, converts each line item in a financial statement to a percentage of a base item. This technique allows you to compare financial statements of companies of different sizes and evaluate the relative significance of various financial statement components. By focusing on the relative size of each financial element, vertical analysis helps you understand how different components contribute to a company’s overall financial picture.

Why Use Vertical Analysis?

1. Comparability: Vertical analysis makes it easier to compare financial statements of companies of different sizes or across different periods. By expressing each item as a percentage, you can see the relative importance of each item, making it easier to compare companies with different scales of operations.
2. Insight: It helps in identifying trends and analyzing the composition of assets, liabilities, revenues, and expenses. Vertical analysis allows you to spot changes in financial statement components over time, providing insights into a company's operational efficiency and financial health.
3. Simplicity: It simplifies the financial statement analysis by reducing the impact of scale and focusing on relative proportions. This makes it easier to understand and interpret the data, especially for students who are new to financial analysis.

Steps to Perform Vertical Analysis

• Select the Base Figure: Determine the base figure for the financial statement you are analyzing.
• For the income statement, the base figure is usually total sales or revenue.
• For the balance sheet, the base figure can be total assets or total liabilities and equity.
• Convert Each Line Item to a Percentage:Express each line item as a percentage of the base figure.
• Income Statement: Divide each expense, income, or profit item by total sales and multiply by 100. For example, if total sales are $1,000,000 and cost of goods sold is $600,000, then the cost of goods sold percentage is (600,000 / 1,000,000) * 100 = 60%.
• Balance Sheet: Divide each asset, liability, or equity item by total assets and multiply by 100. For example, if total assets are $500,000 and cash is $50,000, then the cash percentage is (50,000 / 500,000) * 100 = 10%.
• Analyze the Results: Compare the percentages to previous periods or other companies to identify trends, strengths, and weaknesses. Look for significant changes in the percentages, which can indicate shifts in the company’s financial health or operational efficiency.

Example of Vertical Analysis

Income Statement Example:

In this example, you can see that cost of goods sold accounts for 60% of total sales, gross profit is 40% of total sales, operating expenses are 20% of total sales, and net income is 20% of total sales. This analysis helps you understand the proportion of each expense and profit item relative to total sales.

Balance Sheet Example:

In this balance sheet example, cash makes up 10% of total assets, accounts receivable 20%, inventory 30%, total liabilities 40%, and equity 60%. This provides a clear picture of the composition of the company's assets and liabilities.

Detailed Steps for Conducting Vertical Analysis

• Gather the Financial Statements: Obtain the relevant financial statements for the periods or companies you are analyzing. Ensure that the statements are complete and accurate.
• Identify the Base Figure: Determine the base figure for each financial statement. This is the figure against which all other items will be compared.
• Income Statement: The base figure is typically total sales or revenue.
• Balance Sheet: The base figure can be total assets, total liabilities, or total equity, depending on what you are analyzing.
• Calculate Percentages: For each line item in the financial statement, divide the item amount by the base figure and multiply by 100 to get the percentage.
• Income Statement Example:
• Cost of Goods Sold: (Cost of Goods Sold / Total Sales) * 100
• Gross Profit: (Gross Profit / Total Sales) * 100
• Balance Sheet Example:
• Cash: (Cash / Total Assets) * 100
• Accounts Receivable: (Accounts Receivable / Total Assets) * 100
• Create a Common-Size Statement: Prepare a new statement where each line item is expressed as a percentage of the base figure. This is your common-size statement.
• Interpret the Results: Analyze the percentages to identify trends and insights. Compare the percentages across different periods or companies to understand changes in the financial structure and performance.
• Use Comparative Data: If possible, compare the common-size statement with industry averages or key competitors. This helps in benchmarking the company's performance against peers.

Tips for Effective Vertical Analysis

1. Consistency: Ensure that the base figure is consistent across all periods or companies you are comparing. Inconsistencies can lead to misleading conclusions.
2. Multiple Periods: Analyze multiple periods to identify trends. A single period might not provide enough context, but examining several periods can reveal patterns and shifts in financial performance.
3. Comparative Analysis: Compare with industry averages or competitors to gain deeper insights. This can help you understand how the company is performing relative to its peers.
4. Supplement with Horizontal Analysis: Use horizontal analysis in conjunction with vertical analysis to get a comprehensive view. Horizontal analysis looks at changes in financial statement items over time, providing another layer of insight.
5. Understand the Business Context: Consider the broader business context and any external factors that might be influencing the financial statements. This helps in making more informed and accurate interpretations.
6. Use Visual Aids: Create charts and graphs to visualize the data. Visual aids can make it easier to spot trends and communicate your findings effectively.

Practical Applications of Vertical Analysis

1. Evaluating Profitability: By analyzing the income statement using vertical analysis, you can assess the company's profitability. For example, you can determine how much of each dollar of sales is consumed by the cost of goods sold and operating expenses, and how much remains as net income.
2. Assessing Financial Structure: Vertical analysis of the balance sheet helps in understanding the company’s financial structure. You can see the proportion of assets funded by liabilities versus equity, which provides insights into the company's financial leverage and stability.
3. Identifying Cost Structure: Vertical analysis can reveal the company's cost structure. For example, a high percentage of sales going to cost of goods sold might indicate a need to improve cost management or pricing strategies.
4. Trend Analysis: By comparing vertical analysis percentages over several periods, you can identify trends. For example, increasing operating expenses as a percentage of sales might signal rising costs that could impact profitability.
5. Benchmarking:Comparing vertical analysis results with industry averages or key competitors helps in benchmarking performance. This can reveal areas where the company is outperforming or underperforming relative to its peers.

Conclusion

Vertical analysis is a powerful tool for comparing financial statements and gaining insights into a company's financial health. By converting financial statement items to percentages, you can easily compare different companies or periods, identify trends, and make informed decisions. Utilizing this method in your assignments will enhance your financial analysis skills and impress your instructors with your thorough understanding of financial statement comparison.