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Balance Sheet Vertical Analysis: What It Is and How It Works
Do you want to take your financial analysis skills to the next level and get more detailed insight into your financial statements? Learning how to perform a vertical balance sheet analysis can equip you with the skills to extract actionable insights into your company’s current financial health.
Vertical analysis provides a better understanding of how each line item on the balance sheet fits into the company’s financial structure and is an invaluable decision-making tool.
Read on to learn more about vertical analysis of a balance sheet, how to perform one, and some limitations and drawbacks of this analytical tool.
What Is a Vertical Analysis?
A vertical analysis, also known as common-size analysis, is a method of financial statement analysis that shows each line item as a percentage of a base figure within the statement.
So, in a vertical analysis of a balance sheet, every line item — cash, accounts receivable, fixed assets, accounts payable, stockholders equity, etc. — is shown as a percentage of total assets. In a vertical analysis of an income statement, every line item is shown as a percentage of gross sales.
This type of analysis enables businesses to view the relative proportions of account balances, compare internal changes over time, and identify trends. It’s an effective tool for comparing a company’s financials to those of competitors and an industry benchmark because it allows for easy, straightforward comparisons across different periods and companies of varying sizes.
Vertical Analysis Formula
The formula for vertical analysis is straightforward. You simply divide the figure for a specific line item by the total assets (for a balance sheet) or total sales (for an income statement) and then multiply the result by 100 to get a percentage. This formula can be expressed as:
Vertical Analysis Percentage = (Individual Line Item / Total Assets or Total Sales) * 100
Converting the raw numbers into percentages provides a clearer picture of the proportion of the asset or liability in the context of the company’s total financial resources.
Example of the Vertical Analysis Formula
Let’s look at an example to see how applying the vertical analysis formula might work in the real world.
Say Jackson Widget Company’s balance sheet shows the following amounts as of December 31, 2023:
- Cash: $100,000
- Accounts Receivable: $40,000
- Fixed Assets: $50,000
- Accounts Payable: $30,000
- Notes Payable: $10,000
- Capital Stock: $10,000
- Retained Earnings: $140,000
Based on the information above, Jackson Widget Company’s total assets are $190,000. That’s $100,000 in cash plus $40,000 in accounts receivable plus $50,000 of fixed assets.
So a vertical analysis would show Cash as 53% of total assets ($100,000 / $190,000) * 100 = 52.63%), accounts receivable as 21% of total assets ($40,000 / $190,000) * 100 = 21.05%), and so on.
How to Perform a Vertical Analysis on Your Balance Sheet
Performing a vertical analysis on your balance sheet is a strategic way to gain valuable insights about your business’s financial standing. By converting each line item into a percentage of total assets, you can uncover patterns, identify areas of strength and weakness, and make informed decisions about your company’s future. Here is a step-by-step guide on how to perform a vertical analysis on your balance sheet:
Step 1: Gather your balance sheet figures
First, gather the balance sheet figures for each line item, such as cash, accounts receivable, fixed assets, etc. You can likely export the company’s financial statements from your accounting software to an Excel spreadsheet for easy analysis.
Step 2: Identify total assets
The first step is to find the Total Assets figure on your balance sheet. This primary variant serves as the base figure for your vertical analysis.
Step 3: Calculate the percentage for each line item
For each line item on the balance sheet, divide it by the Total Assets and multiply the result by 100. This gives you the percentage each line item represents of the Total Assets.
Step 4: Interpret the results
Analyze the percentages to identify patterns and trends. Look for items with a significant percentage of Total Assets, as these could represent areas of vulnerability or strength.
Step 5: Compare with industry benchmarks
Compare your results with industry benchmarks or similar companies to see how your business stacks up.
Step 6: Use the results for decision-making
Use the insights gained from the vertical analysis in your decision-making processes. This could influence your budgeting, forecasting, and strategic planning.
Example of Vertical Analysis
Returning to our example above, a vertical analysis of Jackson Widget Company’s balance sheet would look like this.
Account | Total | Percentage |
Cash | $100,000 | 53% |
Accounts Receivable | $40,000 | 21% |
Fixed Assets | $50,000 | 26% |
Total Assets | $190,000 | 100% |
Accounts Payable | $30,000 | 16% |
Notes Payable | $10,000 | 5% |
Total Liabilities | $40,000 | 21% |
Capital Stock | $10,000 | 5% |
Retained Earnings | $140,000 | 74% |
Total Equity | $150,000 | 79% |
Total Liabilities and Equity | $190,000 | 100% |
Horizontal vs. Vertical Analysis
While vertical analysis focuses on the relative size of different line items and their ratios in the same period, horizontal analysis, on the other hand, involves studying the trends and changes in these line items over multiple periods. In vertical analysis, each line item in the financial statement is expressed as a percentage of a base figure in the same period (for example, the total assets or gross sales). However, in horizontal analysis, the relative change in a line item from one period to the next is calculated and typically presented as a percentage change.
This approach provides insights into patterns over time, highlighting increases, decreases, or trends. For example, it can help identify if a company’s accounts receivable has steadily increased over the past three years, which could indicate a problem with credit and collection policies.
Both vertical and horizontal analysis methods provide valuable information/insights. When used together, they offer a comprehensive view of the company’s financial health.
Limitations and Drawbacks of Vertical Analysis
Despite the benefits and insights that vertical analysis can provide, it’s essential to acknowledge its limitations and drawbacks.
Here are a few of those constraints.
- Provides insight into a particular point in time rather than over a period. One major limitation is that vertical analysis only provides a snapshot of a company’s financial health at a specific point in time. This means it may not adequately capture fluctuations that occur throughout the year.
- Financial statement errors can distort results. A useful vertical analysis depends on having accurate financial data. Any errors or manipulations in the figures used can distort the results.
- Lacks context. Vertical analysis also falls short when it comes to providing context. While it’s useful for comparing companies of different sizes, it doesn’t account for differences in industries or markets. A ratio that may seem strong in one sector could be weak in another.
- Doesn’t provide a complete picture. Finally, a vertical analysis of a balance sheet doesn’t provide any information on the company’s cash flows, gross sales or gross profit, all of which are vital aspects of assessing a company’s financial health.
To overcome these limitations, it’s a good idea to use vertical analysis in conjunction with other financial analysis techniques, such as horizontal analysis or ratio analysis, as well as other financial ratios.
Vertical analysis of a balance sheet can be a powerful tool to understand your company’s performance or how two businesses compare. Try it with your next financial analysis and see if it provides useful insights or helps you track progress toward goals.
If you want to take your variance analysis to the next level, check out FloQast Variance Analysis. It offers a better way to perform flux and budget variance analysis by automating the data collection process and integrating with your ERP.