Vertical Analysis – Benchmark Against Competitors in 4 Steps

A vertical analysis is a quantitative analytical tool that shows the relationship between your total sales and each item in a financial statement, also known as the cash flow statement or income statement. It’s a useful tool to show the contribution of different factors to total sales so you can identify emerging trends and formulate more cost-effective business strategies.

Here at Business2Community, we’re committed to sharing the most useful techniques for your business development. In this article, we’ll walk you through everything you need to know about vertical analysis and how to perform one.

What is a Vertical Analysis?

A vertical analysis is a quantitative analytical tool to measure the relative proportions of the components in financial statements like costs, net income, expenses, and liabilities to its total sales. A vertical analysis enables you to decipher your company’s financial statement and understand the contribution of each component to its success.

It presents different line items as a percentage of the total sales to show their contribution/weight. According to the results, you can strategize to minimize costs and maximize efforts.

Financial analysis relies on this technique so you can customize resource allocation methods to nurture sales growth and take advantage of possible emerging trends. It sets the groundwork for more complex calculations in the decision-making process.

Vertical Analysis vs Horizontal Analysis

Both vertical analysis and horizontal analysis are useful tools for analyzing financial statements but they are used for different purposes. While a vertical analysis compares different elements in the same period to understand their effects on profits, a horizontal analysis looks at the company’s financial statements over several accounting periods to observe relative changes.

For example, by looking at a vertical analysis, you can tell that expenses account for 30% of your total sales in 2024. With a horizontal analysis, you can compare final sales in a three-year period as a percentage of the most recent year’s sales.

How to Complete a Vertical Analysis

Here, we’ll look at the steps you need to take to complete a vertical analysis for your business.

Step 1: Gather the Data

To conduct a vertical analysis, you first need to gather the actual dollar amounts of each item in your income statement.  Construct the income statement in dollar amounts as usual.

Step 2: Calculate the Percentage

Taking the total sales as your base figure, use the vertical analysis formula to calculate the percentage of each line item in the income statement:

Vertical analysis = (Individual item / Total sales) x 100

You’ll find some companies omitting the percentage symbol (%) in this financial statement analysis. It is a matter of presentation preference and does not affect the results.

Step 3: Present the Results

After computing the line item percentages, present them in a table with the sales percentage (100%) on top. There is no particular rule in arranging the order of the line items. You can rank them by their percentage size or categories.

This vertical analysis example created by Indeed demonstrates how this technique reveals the relative portions of each item. The income statement unit is in millions of dollars ($).

In this example, the cost of goods sold accounts for 55.8% of the total sales, weighing the heaviest in this vertical analysis, and is on top of the table. In second place, gross profit contributes to 44.2% of the revenues.

Ranking line items by their weight systematically presents each factor’s role in the income statement.

In another example, we can see that factors are ranked by their importance. The company is most interested in knowing how the cost, profit, and expenses contribute to sales. Although the gross profit holds the most weight at 80%, followed by expense at 40%, the company decided to put the cost (20%) first for internal purposes.

You can choose to rank the line items in a convenient and meaningful way for your company to construct a financial statement as a vertical analysis. An income statement presented in percentages is sometimes called a common-size income statement as well.

Step 4: Interpret the Results

Once you have your table prepared, you can use it to understand what element of your business contributes most to sales. You can then use this information to formulate strategies to improve different areas of your business or boost well-performing ones so that they continue to contribute to your sales.

You can access the accounting statements for companies that are traded publicly and do the same vertical analysis calculation to see where their sales come from. This is a way you can check if your business matches with large companies in your sector.

Examples of Vertical Analysis

To demonstrate its real-life applications, here are some examples of vertical analysis and how you can utilize them in curating a high-performing business model.

Example 1: Vertical Analysis in an Income Statement for Trend Analysis

Using percentages to make an industry comparison is much more meaningful than using numbers. Due to size and scale differences, it is illogical to assume companies have the same dollar amounts in their financial statements.

You can compare the ratios of marketing expenses or net profit with industry averages to determine how well/poorly you are doing and identify trends in the sector. You can specifically check out two or more companies’ financial statements to further investigate where firms distribute their costs and assets and if these key trends are found in various companies or just one company.

Example 2: Identifying Important Assets in a Balance Sheet

Other than using this tool to analyze your financial statement, you can also use vertical analysis to break down your balance sheet composition. Instead of dividing each item by the total sales, you can divide it by the total assets.

The relationship between items and total assets offers you vital insights into the strengths and weaknesses of your company. When you see there are more liabilities than assets in a certain period on the balance sheet, you can strategize accordingly.

Example 3: Budget Your Costs and Manage Cash Inflows

Using this proportional analysis, you can better control total cash inflows and manage budget costs. You can pick out expenses with bigger percentages and work on how you can reduce them. You can also look at each product’s contribution to centralize production on fast-selling items. This financial statement analysis technique is crucial for firms to budget their upcoming production.

Limitations of Vertical Analysis

Being a simple quantitative analytical tool, a vertical analysis is handy and practical. However, there are a few disadvantages to this technique. You should be mindful of its limitations when interpreting the results.

First, it does not set acceptable benchmarks. Knowing each item’s percentage of the total assets in the balance sheet or the total sales in a financial statement does not tell you anything about its actual performance.

For example, the results state that your total assets include 30% of liabilities. You have no way of knowing if the number is too high with this tool alone. The analysis does not set standards about the acceptable range for liabilities. You have to set your own benchmarks, targets, and expectations when adopting this method.

Also, it does not reflect seasonable or short-term changes. If you see that your net profit accounts for a huge ratio in a new income statement, it could be easy to assume that the company is doing well. However, it could be due to a seasonal change in costs or sales volume, such as a homewares store selling more beach towels over summer than winter. It could lead to production issues if you mistakenly adjust your strategies because of the results.

You can use other methods like horizontal analysis or descriptive statistics to gather insights from the company’s historical data for the most accurate information.

The Value of Vertical Analysis

Vertical analysis is an incredibly potent tool that conveniently and cost-effectively evaluates your costs, assets, and profits on a comparative basis so you can look at your financial statements in more detail. It helps the company’s management teams to formulate appropriate strategies and prioritize goals to focus on.

As a business owner, operations manager, or accountant, you need to use tools like vertical analysis to better understand your business. You can take advantage of your internal information as well as competitor information like accounts released by publicly listed companies, to make comparisons.

Adopting vertical analysis together with other analytical tools can deliver insights that greatly boost sales and manage costs. It is a simple technique to give your business a head start in the competition.

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