Financial analysis allows financial statement users to evaluate company performance and make decisions. Financial analysis involves calculating ratios, performing horizontal analysis and performing vertical analysis. Financial ratios use selected numbers from the financial statements for each calculation. Horizontal analysis considers the increase or decrease in each account from one year to the next. Vertical analysis considers each item listed on a financial statement in comparison with one another.
Vertical analysis allows financial statement users to compare financial statements between companies and between years. It involves restating each number on the financial statement as a percentage of the base amount. Original financial statements report each item as a dollar amount. Different size companies display vastly different numbers, making comparisons difficult. By restating each number as a percentage, the user can compare the percentage of each item to the same item on a different company’s financial statement, regardless of the size of the company. Also, companies who experience significant growth from one year to the next make comparisons difficult when using the original financial statements. Restating numbers as percentages allows the user to compare financial results from one year to the next within the same company.
Vertical analysis performed on the balance sheet restates each line item as a percentage of total assets. The user locates the total asset value, which equals total liabilities plus owners’ equity, from the balance sheet and makes this number equal to 100 percent. The user divides each line item by the total asset value to calculate the percent for that item. After calculating all of the percentages, the user then verifies that all of the asset line items add up to 100 percent and that all of the liability and equity line items add up to 100 percent.
Vertical analysis performed on the income statement restates each line item as a percentage of total sales. The user locates the total sales value at the top of the income statement and makes this number equal to 100 percent. The user divides each line item by the total sales value to calculate the percent for that item. After calculating all of the percentages, the user then verifies that all of the line items add up to 100 percent.
Vertical analysis provides a useful tool for financial statement users, but it does come with limitations. The company may engage in a unique activity in one year that skews the results of the analysis. For example, if the company purchases new production equipment in one year and sells the old equipment the following year, its fixed assets will show a large increase the first year. The fixed asset percentage reported on the vertically analyzed balance sheet will be higher than normal. Another limitation arises when a user compares financial statements between companies. If the companies operate in different industries, they may report different asset percentages, making the comparison lack meaning. For example, a manufacturing facility will report a large percentage for fixed assets while a service company might report very little in fixed assets. A wise user recognizes the limitations and considers these when using vertical analysis.