The process of restating and summarizing data by establishing ratios and trends is known as financial analysis. The analysis is carried out on a company's financial as well as income statement. The main objective is to know its current financial position and its returns compared to risks. Financial analysis also helps in future forecasting, and has three sud-divisions―vertical analysis, horizontal analysis, and financial ratios.
What is Vertical Analysis?
It is a technique of financial statement analysis, wherein every entry under all three major accounting categories―equities, assets, and liabilities―in a balance sheet are presented as a part of the total account. Using vertical analysis, it is easier to compare balance sheets of small as well as large business organizations. Another benefit is that it helps bring to notice any changes in a business within a year. For example, SOS Corp. has three assets―machinery (US $6 million), inventory (US $10 million), and cash and equivalents (US $4 million). After carrying out the analysis of these assets, the asset column would appear like:
Cash and equivalents: 20%
Cash and equivalents: 20%
Vertical and Horizontal Analysis
In vertical analysis, every amount in the financial or income statement is expressed as a percentage of another amount. Thus, in the assets column, each value is shown as a percentage of the total value of all assets combined. These proportional values, when represented, are known as a common-size balance sheet. Similarly, for income statement, values derived are a percentage of total sales. The restated values form the common-size income statement. Companies find this useful for comparing their financial and income statements with other companies or the industry average.
In horizontal analysis, values on the balance sheet over past years are compared with each other. For example, stock balance represented on the balance sheet for December 31, 2009, 2008, 2007, and 2006, will be a percentage of the stock amount as on 31 December 2006. Amounts are expressed in percentages and not dollars, indicating an increase or decrease in value from the base year. All items on the balance sheet and income statement are compared in this manner. This analysis is also known as trend analysis, and helps a company notice change in a particular item over the years, as compared to changes in other items.
Doing a Vertical Analysis
|Building and Equipment||$15,000||30%|
The above example is an hypothetical balance sheet of a company. To do a vertical analysis of the balance sheet, the total of assets is calculated and given a value of 100%. All other values on the assets side are divided by the total amount, and then expressed as a percentage of total assets. Similarly, for all liabilities, the total is calculated first, and then every individual item is divided by this amount to arrive at the corresponding percentage value. A good way to recheck the calculations is by adding up all percentage values (except the total), which should come up to 100.
|(-) Cost of Goods Sold||$20,000||40%|
|(-) Operating Expenses||$12,500||25%|
|Net Operating Income||$17,500||35%|
|(-) Interest and Tax||$7,500||15%|
The total sales figure is given the value of 100%. All other items will therefore be calculated by dividing them with the sales figure, to get the percentage value. The total of all figures, excluding sales, will not be 100, as certain values are subtracted from the total.
Vertical analysis can also be done on an excel sheet, making the calculations part easier. Every firm, big or small, should carry out a vertical analysis annually to understand their financial position better, which will surely help in implementing future plans.