How To Use Vertical Analysis to Spot a Financial Crisis Before It Happens

Imagine you are sitting with the board members, reviewing the quarterly report of the expenses of your customer support team. You come to realise that your team handled 15,000 tickets last month, spending $180,000 in the process, while your budget for customer support is only $90,000. This double expense will impact your overall operating finances of your company.

If you know that early, then you will take some proactive action and save your business from this financial crisis. In such a scenario, vertical analysis emerges as a powerful tool that can transform confusing amounts into crystal-clear proportional insights. Moreover, with the vertical analysis, you can analyse the potential financial crises and take a proactive approach to handle them.

Do you want to know how VA helps you in handling your fiscal challenges? In his blog, we’ll shed light on how it enables you to manage your expenses and identify financial crises effectively.

Key Learning Points:

• Vertical analysis is a popular financial analysis method in which each component of the line segment represents a percentage of the total base figure.
• Vertical financial analysis focuses on identifying the relationship between different financial components and the total base value to assess the overall performance of the business.
• Horizontal analysis differs from vertical analysis, as it examines one financial component at a time.
• The income statement, balance sheet, and cash flow are three key financial statements used in vertical analysis.
• Learn the key steps that you must follow to conduct a financial analysis to track the growth of your business.
• See the vertical analysis examples to learn how to identify the financial crises in a company before they happen.

What is Vertical Analysis? Understand How it works

According to the My Accounting Course, “Vertical analysis, also known as common-size analysis, is a financial analysis method in which each item is presented as a percentage of a total base figure within the financial statement.”

In the vertical analysis method, you break down the financial statement into various sub-categories, such as revenue and expenses. After this categorisation, you calculate the percentage of each category that represents a small share of the total amount.

In simple words, this financial propositional analysis enables you to list the percentage of each small expense against the company’s total gross value. The key purpose of this method is to give you a clear understanding of the relationship between your financial components and base value. You can also use it to assess your business performance and compare it with previous results or that of your competitors.

How to Calculate Vertical Analysis Results?

Performing vertical analysis is a complex process that involves calculating the percentage of each line segment to determine its contribution to total sales. To calculate the percentage for each segment, you need to follow an easy formula, in which you divide the specific line segment by the total sales and multiply the result by 100. It can be expressed as:

Vertical Analysis = Item in the Segment / Total Amount * 100

Why is it Different from Horizontal Analysis?

The horizontal analysis, also known as trend analysis, is based on identifying the financial trend over a specific period, typically years or quarters. Generally, during a business’s financial analysis, analysts perform horizontal analysis before vertical analysis to gain an overview of their performance during a specific time period. This trend analysis is best suited for companies that have been operating for a long period of time.

To perform this, you can compare the figures from a specific time period to those during the base time period to gain an understanding of the changes that occurred over this period. Analysing financial trends through horizontal analysis can help you track the overall business’s financial growth and identify potential hurdles in this growth.

For instance, you can compare the company’s revenue in one year with the revenue generated in another year using this trend analysis. After that, with the help of these analysis results, you can suggest some effective solutions that can maximise its financial success.

Here are some key differences between these two analyses:

• Horizontal analysis involves calculating values horizontally across a specific period of time, whereas vertical analysis is performed vertically within a column.
• Trend analysis focuses on multiple reporting points simultaneously; on the other hand, vertical analysis examines only one point at a time.
• Horizontal analysis only represents changes over a specific time period, while vertical analysis presents the amount as a percentage of a base amount.

Key Financial Statements for Vertical Analysis

Vertical analysis is applied to three key financial statements: the income statement, balance sheet, and cash flow. Each financial statement is used for a distinct purpose and a specific base figure.

Have a look at the details of each financial statement:

Income Statement

In the vertical analysis for an income statement, each line segment showcases the total sales. This statement minimises the base effect of financial operations by depicting the account expenses as a percentage of the total. Thus, this income sheet is the most effective for businesses that want to compare their growth to different operational scales.

You can calculate the vertical analysis by following the formula below:

Vertical Analysis = Items in the Income Statement / Total Sales * 100

Balance Sheet

Vertical analysis for the balance sheet is a powerful tool that helps businesses track their balance changes over a specific time period. To perform this financial analysis on the balance sheet, you need to prepare a balance sheet first. After preparing this sheet, follow the formula below to conduct VA.

Vertical Analysis = Segment in the Balance Sheet / Total Assets * 100

After obtaining the percentage of each segment, you can compare your vertical analysis results with those of a similar company to track the performance of your business. Apart from that, you can also compare your analysis with the previous year's analysis data and know how much your account balance has changed during this time.

Cash Flow

The vertical analysis for cash flow is conducted to identify how each cash outflow and inflow becomes a percentage of the total cash inflows. This financial analysis for the cash flow statement allows you to compare the financial statements of one company with those of others. This is because you can determine the relative proportion of cash balance changes among them.

To calculate it for the cash flow sheet, follow the formula below:

Vertical Analysis = Individual Cash Flow Item / Total Cash from Operations * 100

Step-by-Step Process to Conduct Vertical Analysis

Conducting a vertical analysis on your financial statements is an effective way to gain valuable insights about your business development. By transforming each line segment into the percentage of the total amount, you can determine the strengths and weaknesses of your company’s finances and make an informed decision about its future.

To conduct this financial analysis, follow the step-by-step guide provided by the experts at Cheap Essay Writing UK.

1: Choose What Statement You Want to Analyse

The first step to conduct the vertical analysis is to determine which statement you want to analyse. That is because you can apply this formula to various statements, such as the income statement or balance sheet. Each of these statements offers unique aspects to the business’s financial situation.

For instance, a balance sheet displays total liabilities of a company, a cash flow statement provides the total assets and revenue, and an income statement provides information about gross values or total sales. Choosing any of these statements allows you to evaluate the performance of your business over the past years and showcases the financial health of your business to your investors. Therefore, select the right statement that you want to assess with the vertical analysis technique.

2: Determine the Base Figure for Percentages

Once you have determined the statement you need to analyse for your business, the next step is to figure out the base figures. For different statements, the base figures are different.

• Income Statement: The base figure for the income statement comprises total sales or total revenue. In this statement, each base item, including product sold, operating cost, or net incomes, are expressed as a key component of the total sales or revenues.
• Balance Sheet: In the balance sheet, the base figure is the sum of total assets, liabilities, and equity. If you have chosen the balance sheet for vertical analysis, then use each line segment of this sheet, such as property, receivables, accounts payable, or debt, as a percentage of the total assets or liabilities.
• Cash Flow:Total cash flow is the base figure of this statement. This base figure helps you determine the total contribution of inflow and outflow to the overall growth of the company.

3: Collect Essential Data

After determining the base figure of your selected financial statement, it’s time to gather all the essential data that you need to conduct the vertical analysis. For instance, you want to study the contribution of accounts payable to the total revenue within the balance sheet.

Then you need to contact your company’s financial record-keeping department to get details about it. Moreover, to perform a thorough financial analysis, you need to collect the same data as your competitor to track the performance of your business. Apart from that, you can explore the publicly available financial data to check the exact proportion of each line segment from the total amount.

4: Calculate Each Line Item as a Percentage of the Base

Now, it’s time for the major step of conducting the vertical analysis: plug your data into the formula. By using this formula, you can calculate the percentage of each line segment as a percentage of the base figure. The formula for performing this financial analysis is as follows:

VA = Item / Base Amount * 100

In this formula, VA represents the vertical analysis or the total percentage that your line segment represents. The item is one of these line segments that you want to analyse, and the base amount is the total amount of the base figure. After dividing the item by the base amount, multiply it by 100 to convert this number into a percentage.

For instance, if the total liabilities are worth $1,000,000 and the accounts payable are $400,000, then the vertical analysis is (400,000/1000,000) * 100 = 40%. That means that accounts payable represent 40% of the company’s total liabilities. You need to apply this formula one by one to all items in your statement sheet and get to know the percentage of each item’s contribution to the total base amount.

5: Chart Your Numbers

Once you have applied the vertical analysis formula to each item in the segment list, the next step is to chart all your analysis results. By charting these numbers, you can easily analyse how the percentage these line segments contributed to the total base amount.

By examining the percentages from these charts, you can detect the current condition of your business. For instance, if the operating cost of your business exceeds its total revenue, it signals inefficiencies in your management.

6: Compare with the Industry Benchmark

The next step of vertical analysis is to compare your analysis results with the industry’s benchmark. This comparison will help you assess whether your company’s performance is improving or worsening.

For example, if your business’s operating cost is 30% of the total revenue and the industry benchmark for this cost is 25%. Then, it means that your operating cost is 5% higher than the average. This indicates that you lack operational management, efficiency, and cost savings.

Thus, with this comparison, you can gain insights into your strengths and weaknesses, helping you make an informed decision, such as whether to invest in advanced technology to enhance operational efficiency, remodel pricing policies, or optimise resource allocation. 

Thus, following these steps will help you conduct vertical analysis to gain proportional insights into your business and identify potential financial crises before they occur. Due to the importance of this topic, teachers often ask students in the accounting subject to write an assignment on it.

However, due to the complexity of this model, it becomes hard for them to complete this task. In such situations, they can avail themselves of assignment writing services from our professional writers and seek their expert assistance in understanding this important topic.

Example of Vertical Analysis

Theories become more powerful and understandable when they are applied to real-world problems. Therefore, we are going to mention some real-world examples of vertical analysis. These examples will illustrate how VA can help you identify potential financial risks and make informed decisions to overcome the potential issues.

Example# 1: Food Company Cost Structure Analysis

In the first example, we have shared the vertical analysis results of two food companies, having identical revenues of $5 million. Have a look at the details of these analysis results to identify which company is performing better.

Company 1

Company 2

The results of the vertical analysis show that the higher sales and administrative costs of company 2, which means that it has poor management and weak sales strategies, so a big chunk of its revenue is allocated to these two departments. Based on our analysis, we can conclude that Company 1 is more efficient than Company 2.

Example# 2: Vertical Analysis on a Balance Sheet of a Software Company 

In the next example, we are going to apply the vertical analysis to the balance sheet of a software company. Check out the results of it:

Asset: Total Assets = $600,000

Liabilities: Total Liabilities = $175,000

Equity: Total Equity = $325,000

In this common-size analysis, we have mentioned each item of the balance sheet as a percentage of total assets, liabilities, and equity. This detailed breakdown of these elements will help you understand the overall performance graph of the company.

Check out some of our key observations based on vertical analysis:

• Cash equivalents comprise 10% of the total assets, indicating that the business is at a higher risk of incurring debt.
• Property, plant, and equipment consists of 30% of total assets, indicating that the business has invested in long-term productive assets.
• Retained earnings have a 40% share of total equity, which means that the company has a good track record of reinvestment in earnings.
• Long-term debt represents 20% of total liabilities, showing that there is a moderate level of debt financing at this company.

Conclusion

Vertical analysis is a powerful tool that is based on financial statement analysis and is used to understand the financial metrics of a company. By converting each item of the line segment into the percentage of total assets, equity, or revenue, it provides valuable insights, key trends, and effective strategies to overcome the potential financial crises even before they happen.

Performing vertical analysis is a challenging task, especially for novice analysts. Therefore, we have come here to help them. In this blog, we have shared the key steps for conducting this financial analysis.

These steps include selecting the appropriate statement, determining the base figure, gathering data, plotting numbers, and comparing them with industry trends. To further clarify the key concept of vertical analysis, we also shared some key practical examples. We hope that our guide will transform your analysis into a walk in the park.

FAQs

Why is Vertical Analysis Important in Accounting?

A vertical analysis is an important financial analysis tool that is commonly used in the accounting realm. This method expresses each component of the financial statement as a percentage of the total base figure. For instance, each line segment is the percentage of the total revenue in the income statement. Likewise, each item given in a balance sheet represents the percentage of total assets.

State the Formula for Vertical Analysis.

Vertical analysis is a technical technique to identify the relationships between different financial components. You can carry out this financial analysis using a simple formula, which is as follows:

Vertical Analysis = (Item of Line Segment / Total base Figure) * 100

When is Vertical Analysis Used in Accounting?

Vertical analysis is a powerful tool for understanding the workings of various financial components within a business. It is commonly used for the following purposes:

• It compares the performances of two companies of different sizes.
• This common-size analysis uncovers the cost structure of a business.
• Vertical analysis reports the financial performance of a business to its investors or stakeholders.

References:

1. My Accounting Course. (n.d.). What is Vertical Analysis? https://www.myaccountingcourse.com/accounting-dictionary/vertical-analysis