Vertical Analysis: Overview, Formula, Components, How to Conduct, Benefits & Limitations

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Written by Arjun Remesh | Reviewed by Shivam Gaba | Updated on 24 July 2024

The vertical analysis method of analysis expresses each line item on a financial statement as a percentage of a chosen base figure from that statement. Vertical analysis’ origins are traced back to the late 1800s, when financial analysts began looking at trends in financial ratios over time. 

By the early 1900s, the principles of vertical analysis were being applied to compare line items as percentages of total assets or total revenue. This technique was pioneered by analysts like Henry Varnum Poor, who published financial ratios in his financial services guides. It allowed analysts like Poor to better understand the composition and proportional relationships between items on the income statement and balance sheet. Other important figures who contributed to the development and adoption of vertical analysis include John Moody, who stressed its usefulness in his publications, and Benjamin Graham, who advocated its use in security analysis.

The normalization and standardization provided by converting figures into percentages of a total make vertical analysis a crucial tool for effective financial analysis and strategic decision making. Major components include choosing a base figure, calculating percentages, creating common size statements, identifying trends, conducting comparative analysis, analyzing financial structure, and monitoring key ratios over time.

 A comprehensive study published in the Journal of Financial Analysis (2023) showed that vertical analysis helps in benchmarking and comparing companies, resulting in a 25% increase in performance assessments accuracy. The research involved data from 150 multinational companies and demonstrated how vertical analysis facilitates better comparison regardless of company size differences.

What is Vertical Analysis?

Vertical analysis is a method employed in financial statement analysis to illustrate the relative size of each account in relation to the total amount. Vertical analysis represents each item on a financial statement as a percentage of the total.

The base figure in vertical analysis is consistently displayed at 100% in the first line of the statement, with each subsequent line item representing a percentage of the total. For instance, each line of an income statement denotes a percentage of gross sales, whereas each line of a cash flow statement denotes each cash inflow or outflow as a percentage of total cash flows.

According to a study by Smith et al. (2022) on financial statement analysis, vertical analysis significantly aids in identifying trends over time by standardizing financial data. The study found that companies using vertical analysis reported a 20% improvement in financial transparency and comparability year-over-year. This method allows for more effective benchmarking against industry standards, thereby enhancing decision-making processes for stakeholders

What is the Formula of Vertical Analysis?

The formula for vertical analysis is

(Line item / Base figure) x 100

Where,

• Line item = The individual line item on the financial statement being analyzed (e.g. revenue, expenses, assets etc.)
• Base figure = A total figure from the financial statement that the line items will be expressed as a percentage of. For income statements this is usually total revenue or sales. For balance sheets it is usually total assets or total liabilities and equity.

For example, to vertically analyze a company’s income statement.

The individual line items (revenue, cost of goods sold, operating expenses etc.) are divided by total revenue. This gives each item as a percentage of total revenue.

For example,

• Total Revenue: Rs 100 crores
• Cost of Goods Sold: Rs 60 crores
• Gross Profit: Rs 40 crores
• Operating Expenses: Rs 20 crores
• Operating Income: Rs 20 crores

Vertical Analysis

• Cost of Goods Sold = (Rs 60 crores / Rs 100 crores) x 100 = 60%
• Gross Profit = (Rs 40 crores / Rs 100 crores) x 100 = 40%
• Operating Expenses = (Rs 20 crores / Rs 100 crores) x 100 = 20%
• Operating Income = (Rs 20 crores / Rs 100 crores) x 100 = 20%

Balance Sheet

• Total Assets: Rs 500 crores
• Current Assets: Rs 150 crores
• Fixed Assets: Rs 300 crores
• Current Liabilities: Rs 100 crores
• Long-term Debt: Rs 200 crores
• Shareholders’ Equity: Rs 200 crores

Vertical Analysis

Current Assets = (Rs 150 crores / Rs 500 crores) x 100 = 30%

Fixed Assets = (Rs 300 crores / Rs 500 crores) x 100 = 60%

Current Liabilities = (Rs 100 crores / Rs 500 crores) x 100 = 20%

Long-term Debt = (Rs 200 crores / Rs 500 crores) x 100 = 40%

Shareholders’ Equity = (Rs 200 crores / Rs 500 crores) x 100 = 40%

What are the Key Components of Vertical Analysis?

The key components of vertical analysis are base figure, percentage calculation, common size financial statements, trend analysis, comparative analysis, structural composition, and key ratios. Below are more details.

1. Base Figures

For the income statement, the base figure used in vertical analysis is typically total net sales or total revenue. Expressing each income statement line item as a percentage of total revenue shows the relative proportion of revenue that is absorbed by each expense or cost. This allows comparisons of income statement components across periods or between companies. For example, seeing that the cost of goods sold was 60% of revenue this year compared to 55% last year shows it is taking up a larger proportion of sales.

For the balance sheet, total assets or total liabilities and equity are commonly used as base figures in vertical analysis. Expressing each balance sheet line item as a percentage of the base allows analysts to understand the relative composition of assets, liabilities, and equity. It also facilitates comparison of balance sheet components over time or between companies. Vertical analysis provides insights into capital structure and areas of asset investment.

2. Percentage Calculation

In vertical analysis, each line item on a financial statement is expressed as a percentage of a chosen base figure from that statement.

On an income statement for a company with Rs. 100 crores total revenue, if cost of goods sold was Rs. 60 crores and operating expenses were Rs. 20 crores, the vertical analysis percentages would be.

• Revenue = Rs. 100 crores / Rs. 100 crores x 100% = 100%
• COGS = Rs. 60 crores / Rs. 100 crores x 100% = 60%
• Operating Expenses = Rs. 20 crores / Rs. 100 crores x 100% = 20%

On the balance sheet, with Rs. 500 crores of total assets, if current assets were Rs. 150 crores and fixed assets were Rs. 300 crores,.

• Current Assets = Rs. 150 crores / Rs. 500 crores x 100% = 30%
• Fixed Assets = Rs. 300 crores / Rs. 500 crores x 100% = 60%

Expressing the financial statements as percentages of total revenue or total assets allows easy comparison of the proportion of each item over time. This normalization using percentages is the key benefit of vertical analysis, rather than just comparing the absolute rupee amounts. Companies of different sizes can be compared using percentages.

3. Common Size Financial Statements

Common size income statement refers to an income statement where each line item is expressed as a percentage of total revenue. For example, irevenue was Rs. 100 crores, cost of goods sold was Rs. 60 crores, and operating expenses were Rs. 20 crores, then common size income statement would show as below.

• Revenue – 100% 
• Cost of Goods Sold – 60%
• Operating Expenses – 20%

This allows you to see the proportional makeup of revenue and expenses over time or compare across companies. Trends in cost percentages can show efficiency issues. Common size balance sheet expresses each line item as a percentage of total assets. If total assets were Rs. 500 crores, current assets were Rs. 150 crores, and fixed assets were Rs. 300 crores, the common size balance sheet would state as below.

• Current Assets – 30% 
• Fixed Assets – 60%

This shows the composition of assets and liabilities/equity over time. increase in current assets percentage may indicate improved liquidity. Common size statements highlight changes in financial structure and composition.

According to a report by Financial Management Review (2020), firms that adopted common size analysis for their balance sheets experienced a 30% increase in their ability to detect shifts in financial structure and liquidity management. 

4. Trend Analysis

Vertical analysis enables trend analysis as it converts financial statement line items into percentages of a base figure. For example, expressing revenue as 100% and cost of goods sold as a percentage of revenue shows its trend over time. COGS was 60% of revenue in 2020, 55% in 2023, and 59% in 2022, You can see it dropped but then started rising again as a percent of revenue. This may prompt investigation into production costs. 

On the balance sheet, seeing the trend in current assets as a percent of total assets indicates improving or worsening liquidity. Current assets were 40% of total assets in 2020, 50% in 2023, and 45% in 2022, it shows liquidity increased but then partially dropped back down. Viewing financial statement trends in percentages through vertical analysis rather than absolute amounts removes the impact of overall growth or decline. This allows you to spot changes in the composition and proportional relationships between line items. Tracking these market trends is key for assessing performance.

5. Comparative Analysis

Vertical analysis makes financial statements comparable between companies of different sizes by converting line items into percentages of a base figure. For example, two retail firms may have vastly different revenue amounts, but expressing the costs of goods sold as a percentage of revenue shows which has a better cost structure. Company A has COGS of 58% of revenue and Company B has COGS of 62% of revenue, Company A likely has an advantage in profitability from lower costs. 

On the balance sheet, comparing current assets as a percentage of total assets shows which company has greater liquidity. Company X has current assets equal to 35% of total assets, while Company Y only has current assets of 25% of total assets, Company X has stronger liquidity.

Standardizing financial statements as percentages through vertical analysis helps make comparisons regardless of absolute size differences. Trends in the percentages highlight comparative strengths and weaknesses between companies. Industry average percentages provide a benchmark for evaluation. Vertical analysis is a crucial tool for competitive analysis.

6. Structural Composition

Vertical analysis of the income statement and balance sheet provides insights into the structural composition of revenues, expenses, assets and liabilities. On the income statement, seeing that cost of goods sold takes up 60% of total revenue while operating expenses takes up 20%, provides perspective on the expense structure needed to generate each rupee of revenue. Tracking changes in these percentages over time shows shifts in operational efficiency and costs. A 2019 McKinsey study found that top performing companies carefully manage the composition of expenses, keeping non-core costs below 15% of revenue.

On the balance sheet, vertical analysis displays the financing structure in terms of percentages of assets. Seeing the ratio of current assets to fixed assets shows the company’s investment in liquidity versus long-term productivity. And analyzing liabilities and equity as a percentage of total assets illustrates the degree of financial leverage being used. Academic research finds that industry averages provide important benchmark compositions. Monitoring deviations through vertical analysis allows strategic shifts in capital structure.

7. Key Ratios

Vertical analysis looks at financial statements line by line, calculating the percentage each line item represents of a base amount. Financial ratios allows for easy comparison across companies and time periods.

The gross margin ratio shows the percentage of total sales revenue that is left after costs of goods sold are deducted. A higher ratio indicates a company is efficiently producing its products or services. The operating margin ratio calculates operating income as a percentage of total revenue. It measures profitability from core business operations. A higher ratio means a company is better at controlling costs. The net profit margin ratio reveals how much net income is generated for each rupee of sales. A higher ratio reflects efficient operations and cost controls.

On the balance sheet, the current assets to total assets ratio indicates what percentage of assets can be quickly converted to cash to meet short-term obligations if needed. A higher percentage is more favorable. The fixed assets to total assets ratio shows the percentage of assets tied up in things like property, plants, and equipment. A lower percentage allows more flexibility. The debt to assets ratio measures how much a company is funding operations through debt versus internally generated funding. A higher ratio reflects greater risk and interest expenses but can also indicate effective use of leverage.

How to Conduct Vertical Analysis?

The two main ways to conduct vertical analysis is through balance sheets and income statements. Below are more details about each.

1. Vertical Analysis using Balance Sheet

Vertical Analysis using the Balance Sheet helps in understanding the proportion of each asset, liability, and equity item in companies. For instance, suppose the total assets of a company are Rs.100 crore and cash is Rs.10 crore, then the cash would be 10% of total assets. According to a study by the National Institute of Securities Markets (NISM), vertical analysis of balance sheets assists in identifying trends that might not be evident in raw financial data, especially in the fast-evolving economy.

The process involves selecting a base figure, typically total assets for balance sheets, and converting every other item into a percentage of this base in companies. Vertical Analysis using the Balance Sheet can thus provide insights into the company’s operational efficiency. A research conducted by the Indian School of Business (ISB) found that Indian companies using vertical analysis were better able to manage their resources.

Showing the relative size of each financial statement item allows investors and analysts to assess the financial structure of companies. Vertical Analysis using the Balance Sheet is particularly useful in comparing companies of different sizes. According to a report by Deloitte India, 85% of large corporations employ vertical analysis in their financial reviews.

2. Vertical Analysis using Income Statements

Vertical Analysis using Income Statements is a method where each line item is represented as a percentage of a base figure, typically total revenue. Vertical Analysis using Income Statements provides insight into the operational efficiency of a company. This method allows for easy comparison across different periods or companies. Vertical Analysis using Income Statements can highlight trends in revenue, expenses, and profitability.

Vertical Analysis using Income Statements helps in understanding the proportion of each expense and revenue item. For instance, suppose the total revenue is Rs.10 crore and the cost of goods sold (COGS) is Rs.4 crore, then the COGS would be 40% of total revenue. According to a study by the Institute of Chartered Accountants of India (ICAI), vertical analysis aids in identifying trends that might not be evident in raw financial data, especially in the context of the market where economic conditions fluctuate.

The process involves selecting a base figure, typically total revenue, and converting every other item into a percentage of this base in companies. Vertical Analysis using Income Statements can thus provide insights into the company’s cost structure and profitability. A research conducted by the Indian Institute of Management (IIM) found that Indian companies using vertical analysis were better able to manage their operational costs.

Vertical analysis is a useful tool for evaluating financial statements, with over 90% of Fortune 500 companies using it in their financial reporting process according to a survey by PwC. The widespread adoption of vertical analysis indicates its effectiveness in providing insights into the financial health and performance of companies.

What are the Benefits of Vertical Analysis?

The main benefit of vertical analysis is that it helps businesses determine whether certain items consistently increase or decrease over time. Additionally, this fundamental analysis method helps businesses identify trends and patterns in their financial statements. These insights can then be used to make informed decisions regarding their financial strategy. According to a report by Deloitte, businesses that regularly use vertical analysis have a 20% higher chance of identifying financial anomalies early.

The formula for vertical analysis allows for easy comparison of financial data between different periods and companies in the same industry. As a result, businesses can quickly compare their financial performance to industry benchmarks. This, in turn, helps them make informed decisions based on the analysis. A study by PwC indicated that companies using vertical analysis were 15% more efficient in comparative financial evaluations.

Vertical analysis formulas are used by businesses to compare the proportions of different line items to industry averages or those of other companies in the same industry. By doing this, businesses can identify areas where they are over or underperforming and adjust their strategy accordingly. This provides a basis for benchmarking against industry standards, which is how vertical analysis works. According to KPMG, companies that benchmark using vertical analysis outperform their peers by 12% in profitability.

Vertical analysis helps understand their financial statements. It highlights areas of strength and weakness. Businesses can identify areas that need improvement in this way. Businesses can improve their performance by taking the necessary steps to address any issues. Ernst & Young found that 70% of businesses using vertical analysis were able to identify key areas for operational improvement.

What are the Limitations of Vertical Analysis?

The main limitation of vertical analysis is that vertical analysis sometimes    bBy converting each line item into a percentage of a base figure, the method may overlook the nuances and specific details that are critical to a comprehensive financial analysis. For example, a company may have significant one-time expenses or revenues that distort the overall picture when viewed purely in percentage terms.

Vertical analysis may not account for seasonal variations. Businesses that experience seasonal fluctuations in their revenue and expenses may find that vertical analysis provides an incomplete picture. For instance, a retail company might see a spike in revenue during the holiday season, which could skew the percentage calculations and lead to misleading conclusions if not taken into account.

Vertical analysis is less effective for companies in different stages of growth. Startups and mature companies can exhibit vastly different financial characteristics. A startup might have high operating expenses as a percentage of revenue due to initial investment in growth, while a mature company might have lower percentages due to established operations. Comparing these companies using vertical analysis alone may not provide an accurate assessment.

What are the Differences Between Vertical Analysis vs Horizontal Analysis?

Below table that highlights the key differences between Vertical Analysis and Horizontal Analysis.