Vertical Analysis - definition & overview

Vertical Analysis, a term often used in the realm of finance and accounting, is a method of financial statement analysis in which each entry for each of the three major categories of accounts, namely, assets, liabilities and equities in a balance sheet is represented as a proportion of the total account. It is a useful tool for small businesses in Australia, as it allows them to understand their financial health in a comprehensive manner.

Small businesses can use vertical analysis to compare their financial statements over different periods, or against other businesses, even larger ones. This method of analysis is particularly useful for small businesses as it allows them to identify trends, understand their financial position, and make informed decisions about future actions. It's a tool that empowers businesses, giving them the knowledge and confidence to take control of their financial destiny.

Understanding Vertical Analysis

Vertical analysis is a method of financial statement analysis in which each line item is listed as a percentage of a base figure within the statement. Thus, each line item on an income statement is stated as a percentage of gross sales, while each line item on a balance sheet is stated as a percentage of total assets or total liabilities and shareholder equity.

By expressing the items in proportion to some size-related measure, vertical analysis results in common-size financial statements. A common-size balance sheet allows for the relative level of each account to be compared with those of other companies, regardless of their size.

Importance of Vertical Analysis

Vertical analysis is important for a small business as it gives a clear picture of the proportion of resources that are being allocated to different operations. It helps in identifying whether the resources are being utilised efficiently or not. It also helps in identifying the areas where the costs are going out of control and need to be checked.

Furthermore, vertical analysis helps in comparing the financial statements of different periods of the same firm, or with other firms, irrespective of their size. This is particularly useful for small businesses as it provides them with a tool to compare their performance with larger competitors, and identify areas where they can improve.

Limitations of Vertical Analysis

While vertical analysis is a powerful tool, it is not without its limitations. One of the main limitations is that it only provides a snapshot of a company's financial health at a particular point in time. It does not provide information about a company's performance over a period of time, which can be crucial for small businesses.

Another limitation is that it does not provide any information about the absolute amounts. For example, a small business may have a higher percentage of assets in cash than a larger competitor, but the absolute amount of cash may be significantly less. Therefore, while vertical analysis can provide useful insights, it should be used in conjunction with other financial analysis tools.

Performing Vertical Analysis

Performing vertical analysis involves several steps. The first step is to choose the financial statement to be analysed. This could be the income statement, balance sheet, or cash flow statement. Once the statement has been chosen, the next step is to choose the base figure. This is the figure to which all other figures will be compared.

After the base figure has been chosen, each line item on the financial statement is then expressed as a percentage of the base figure. This results in a common-size financial statement, which can be used for further analysis. The final step is to interpret the results, and make decisions based on the insights gained.

Choosing the Financial Statement

The choice of financial statement to be analysed depends on the information that the small business is seeking. For example, if the business wants to understand its profitability, it would choose the income statement. If it wants to understand its financial position, it would choose the balance sheet. If it wants to understand its cash flows, it would choose the cash flow statement.

Each financial statement provides different insights, and the choice of statement should be based on the specific needs and objectives of the small business. It's important to remember that each statement provides a piece of the puzzle, and to get a complete picture, all three statements should be analysed.

Choosing the Base Figure

The choice of base figure depends on the financial statement that has been chosen. For the income statement, the base figure is usually sales revenue. For the balance sheet, the base figure is usually total assets or total liabilities and shareholder equity. For the cash flow statement, the base figure is usually net cash provided by operating activities.

The base figure is important as it provides the benchmark against which all other figures are compared. It should be chosen carefully, as the choice of base figure can significantly impact the results of the vertical analysis.

Interpreting the Results of Vertical Analysis

Interpreting the results of vertical analysis involves understanding the relationships between different line items on the financial statement. For example, a high percentage of assets in cash could indicate a strong liquidity position, but it could also indicate a lack of investment in other areas of the business.

Similarly, a high percentage of liabilities could indicate a high level of debt, which could be a cause for concern. However, it could also indicate that the business is leveraging debt to finance growth, which could be a positive sign. Therefore, it's important to interpret the results in the context of the business's overall strategy and objectives.

Using the Results for Decision Making

The results of vertical analysis can be used for a variety of decision-making purposes. For example, they can be used to identify areas where costs are out of control, and action needs to be taken. They can also be used to identify areas where investment is needed, or where resources could be reallocated for better returns.

Furthermore, the results can be used to compare the business's performance with that of its competitors, and identify areas where it is underperforming or outperforming. This can provide valuable insights for strategic planning and competitive positioning.

Combining Vertical Analysis with Other Tools

While vertical analysis is a powerful tool, it is most effective when used in conjunction with other financial analysis tools. For example, horizontal analysis, which involves comparing financial statements over different periods, can provide insights into trends and changes over time.

Similarly, ratio analysis, which involves comparing different line items on the financial statement, can provide insights into relationships and proportions that may not be apparent from the vertical analysis alone. Therefore, small businesses should consider using a combination of financial analysis tools to get a comprehensive understanding of their financial health.

Conclusion

Vertical analysis is a powerful tool that can help small businesses in Australia understand their financial health in a comprehensive manner. It provides a snapshot of a company's financial position at a particular point in time, and can be used to compare performance over different periods, or against other businesses.

While it has its limitations, when used in conjunction with other financial analysis tools, it can provide valuable insights that can inform decision making and strategic planning. It's a tool that empowers small businesses, giving them the knowledge and confidence to take control of their financial destiny.