Unit 2: Financial Statement: A Review

Lesson 2.6
Vertical Analysis
Contents
Introduction 1

Learning Objectives 2

Quick Look 3

Learn the Basics 4

Vertical Analysis 5
Uses of Vertical Analysis 6
Performing Vertical Analysis 6
Steps in Performing Vertical Analysis 6
Performing Vertical Analysis on an Income Statement 7
Performing Vertical Analysis on Balance Sheet 11
Advantages and Disadvantages of Vertical Analysis 13
Advantages 14
Disadvantages 14

Keep in Mind 15

Try This 16

Practice Your Skills 17

Challenge Yourself 18

Photo Credit 19

Bibliography 19
Unit 2: Financial Statement: A Review

Lesson 2.6

Vertical Analysis

Introduction

Why do people look in their left and right directions when crossing the streets? Why is
looking straight ahead not enough to ensure your safety? Plenty of activities and
movements happen on the road. Pedestrians and vehicles may be moving with you or
toward you. You have to navigate wide and narrow spaces to reach your destination. If you
do not observe all movements in your surroundings, you cannot anticipate possible
untoward incidents. You may also compromise your safety and the safety of others around
you.

This principle is also applied in business and finance management. Managers analyze the
movements of figures in all directions. When examining financial statements and

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Unit 2: Financial Statement: A Review

information, they also look backward, forwards, and sideways. It is the only way they can
comprehensively understand a business’s position and performance. Through this, they can
identify present factors, anticipate possible events, and forecast future performance
concerning profitability and efficiency.

This lesson will introduce you to vertical and horizontal financial statement analysis.
However, the discussion will focus on the first half of the process—vertical analysis.

Learning Objectives DepEd Competency

Perform vertical and horizontal analyses of

At the end of this lesson, you should be able to
financial statements of a single proprietorship
do the following:
(ABM_BF12-IIIb-8).
● Define vertical analysis.

● Perform vertical analysis of financial

statements.
● Assess the use and limitation of vertical
analysis.

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Unit 2: Financial Statement: A Review

Quick Look

Apples to Apples
As the economy globalizes further, business processes and activities transcend borders.
Companies face competition beyond their domestic counterparts. To survive the
intensifying competition, business owners must enhance their strategies in all fronts of
business operations, such as product development, production, marketing, financing, and
others.

Analyzing their financial performance and position lets companies know their strengths and
weaknesses. It allows them to relate their strategies to other aspects of business
operations. For example, if a company implemented a new process in production, how does
it affect the costs, expenses, revenues, and cash flow?

Although a company needs to be aware of its strengths and weaknesses, success also
entails knowing the performance of your competitors. Competition raises the bar of
efficiency and innovation.

Companies need to constantly measure their performance based on their own goals and
the rapidly changing industry standards to stay ahead of the competition.

Questions to Ponder
1. Why is it important for companies to assess their financial strengths and

weaknesses?

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Unit 2: Financial Statement: A Review

2. Is it necessary for companies to consider comparing their performance with other

companies? Explain your answer.

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3. Do comparisons only work for companies of the same size? Explain your answer.

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Learn the Basics

Recall that in your accounting subject, you learned that financial statements follow generally
accepted accounting principles to allow comparability of data. Thus, accountants and
financial analysts examine financial statements using standardized tools and techniques.

One method in examining the financial performance and position of companies is through
financial statement analysis. This practice analyzes financial information reported in
balance sheets, income statements, and cash flows to pick out patterns and trends. It is a
tool used to conduct comparisons and predictions so that users can develop strategies and
anticipate possible results. Information in financial statements are analyzed vertically and
horizontally to create a clear picture of a company’s financial performance.

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Unit 2: Financial Statement: A Review

Figure 1. Vertical and horizontal analysis provides a clear picture of a company’s financial
performance (Lakada, Lapian and Tumiwa 2017).

Essential Question

How can vertical analysis assist in tactical and strategic business decisions?

Vertical Analysis
A vertical analysis is one of the methods used in financial statement analysis. It is
sometimes called a common-size analysis. The vertical analysis examines the items in a
financial statement by comparing each line item against another item, which are both
reported in the same period. Thus, it is a static analysis that indicates how an item
contributes to the overall performance.

Vertical analysis expresses the relationship of one item to a base figure in the same column
as a percentage. For instance, a vertical analysis on a balance sheet can set the total assets
as the base figure. Other line items, such as cash or long-term assets, will then be compared
to the total assets, and the result will be expressed as a percentage.

As its name suggests, this type of analysis involves vertical or up-and-down movement of
the eyes. This method also allows companies to compare their performance against other
companies in the same industry.

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Unit 2: Financial Statement: A Review

Uses of Vertical Analysis

Vertical analysis is a method used to analyze the items in a single reporting period. However,
it also allows for companies to see the relative change in accounts over time. For example, if
cash was 30% of the total assets last year, companies can compare it to the total percentage
this year.

Vertical analysis is commonly applied on an income statement. The amount in every line item
is compared to the total amount of sales. For instance, you can examine the percentage of
costs of goods sold, operating expenses, and operating income compared to sales.

Another use of vertical analysis is on a business’s balance sheet. This method evaluates the
relationship of the individual assets to total assets, and the liabilities and equity account to
the total liabilities and equity.

Check Your Progress

How can a firm’s management analyze its strengths and weaknesses using
vertical analysis?
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Performing Vertical Analysis

Vertical analysis can be performed on an income statement and a balance sheet. Since the
method measures the relationship between the different elements of financial statements
during an accounting period, vertical analysis can be done even with just one period of data.

Steps in Performing Vertical Analysis

Vertical analysis is performed through the following steps:

Step 1: Prepare the income statement or balance sheet of the period/s you want to analyze.

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Unit 2: Financial Statement: A Review

Step 2: Identify the base item. For income statements, it is the total sales. For the balance
sheet, it can be the total assets or the total liabilities and equity. Assume the base
item as 100%.

Step 3: Compute the percentage of each item of the income statement or balance sheet
compared to the base item. The formula is as follows:

Step 4: Interpret the results. The analysis will not be complete without interpreting the
result and making a decision.

Performing Vertical Analysis on an Income Statement

The following example illustrates a vertical analysis of ABC Merchandising Company’s income
statement. You can see that the base item for this analysis is the net sales. The percentage of
items compared to the base items are shown below:

ABC Merchandising Company

Vertical Analysis of Income Statement
for the Year Ended December 31, 2012

net sales ₱4,950,000 100%

cost of goods sold ₱2,870,000 58%
gross profit ₱2,080,000 42%
operating expenses
selling expenses ₱650,000 13.1%
general expenses ₱612,500 12.4%
total operating expenses ₱1,262,500 25.5%
operating income ₱817,500 16.5%
interest expenses ₱120,000 2.4%
income before tax ₱679,500 14.1%
income tax expense ₱181,800 3.7%
net income ₱515,700 10.4%

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Unit 2: Financial Statement: A Review

The results show that the cost of goods sold1 in this period is 58% of the total sales, while the
operating income comprises 16.5% of the net sales.

To illustrate how vertical analysis is performed in comparing the performance of two

companies, examine the financial information provided by Companies ABC and DEF. The
common sales must be used as the base item to ensure that these companies are of the
same size or common size. Below the sales row, you will see the percentage of each item
compared to the base item.

Company ABC Company DEF

sales ₱150,000 100% ₱150,000 100%

sales returns and allowances ₱25,000 17% ₱13,000 9%
net sales ₱125,000 83% ₱137,000 91%
cost of goods sold ₱50,000 33% ₱75,000 50%
gross profit ₱75,000 50% ₱62,000 41%
operating expenses
selling expenses ₱10,000 7% ₱4,930 3%
general expenses ₱5,500 4% ₱2,738 2%
total operating expenses ₱15,500 10% ₱7,668 5%
operating income ₱59,500 40% ₱54,332 36%
interest expenses ₱12,000 8% ₱2,930 2%
income before tax ₱47,500 32% ₱51,402 34%
income tax expense ₱19,000 13% ₱20,561 14%
net income ₱28,500 19% ₱30,841 21%

1
cost of goods sold (noun) - an amount calculated by subtracting the merchandise inventory at the end of the year from
the goods available for sale (beginning inventory plus net purchases) during the period

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Unit 2: Financial Statement: A Review

Closer Look

Vertical Analysis of SR&A

The percentage of Company ABC’s sales returns and allowances (SR&A)
was calculated by dividing ₱25,000 by the total sales, ₱150,000, then
multiplying by 100:

The results help compare the performance of two companies. Consider their sales return
and allowances: 17% of Company ABC’s sales are SR&A, while it is 9% in Company DEF. You
can interpret that Company ABC is more likely to produce defective products than Company
DEF.

Moreover, looking at their cost of goods sold (COGS), Company DEF is significantly spending
more than Company ABC. Another interpretation is that Company ABC receives its cost of
goods sold at a reasonable price. At the same time, Company DEF is either being
overcharged for the cost of goods sold or considering another supplier.

You may also perform a vertical analysis on the income statement of the same company
covering two or more years:

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Unit 2: Financial Statement: A Review

ABC Merchandising Company

Vertical Analysis of Income Statement
for the Year Ended December 31, 2012

2013 2012

net sales ₱4,462,895 100% ₱4,950,000 100%

cost of goods sold ₱2,125,980 48% ₱2,870,,000 58%
gross profit ₱2,336,915 52% ₱2,080,000 42%
operating expenses
selling expenses ₱907,000 20% ₱650,000 13.1%
general expenses ₱650,790 15% ₱612,500 12.4%
total operating expenses ₱1,557,790 35% ₱1,262,500 25.5%
operating income ₱779,125 17% ₱817,500 16.5%
interest expenses ₱125,000 3% ₱120,000 2.4%
income before tax ₱654,125 15% ₱679,500 14.1%
income tax expense ₱264,800 6% ₱181,800 3.7%
net income ₱389,325 9% ₱515,700 10.4%

Consider the year 2013. The cost of goods sold comprises 48% of the net sales, while 58%
from the previous year. Thus, as the cost of goods sold increases, the gross profit decreases;
there is a high chance that net income will also decrease.

Check Your Progress

Choose one of the results of the vertical analysis done on ABC

Merchandising Company’s income statement for 2012 and 2013, and
interpret it.
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Unit 2: Financial Statement: A Review

Performing Vertical Analysis on Balance Sheet

The central issue in the vertical analysis of balance sheets is determining which denominator
should be used in the percentage calculation. Commonly, the total asset2 is used as the
denominator, since it is always equal to the liabilities3 and equity. Hence, in performing a
vertical analysis, the accounting equation must also be considered.

To illustrate how vertical analysis is performed on a balance sheet, examine the balance
sheet provided by ABC Merchandising Company. The total asset and the total liabilities and
equity are set as base items. The percentage of each item compared to the base items are
shown below.

ABC Merchandising Company

Vertical Analysis of Balance Sheet
as of December 31, 2012

assets
cash and cash equivalents ₱193,395 34%
accounts receivables ₱21,575 4%
inventories ₱51,980 9%
current assets ₱266,950 47%
equipment ₱303,910 53%
total assets ₱570,860 100%

liabilities
accounts payable ₱23,000 4%
notes payable ₱75,000 13%
total liabilities ₱98,000 17%

equity
common stock ₱325,000 57%
retained earnings ₱147,860 26%
total equity ₱472,860 83%
total liabilities and equity ₱570,860 100%

To compare a company’s performance over two or more periods, you may set the total
assets or the total liabilities and equity as the base items. Compute the percentage of
relevant items based on the figure of the base item. You will see in the example below the
percentage of each item compared to the base item.

2
asset (noun) - probable future economic benefit obtained or controlled by an entity
3
liabilities (noun) - probably future sacrifices of economic benefits arising from present obligations of an entity

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Unit 2: Financial Statement: A Review

2016 2015

assets
current assets ₱2,315,000 56% ₱1,050,000 46%
property, plant, and equipment ₱1,825,000 44% ₱1,215,000 54%
total assets ₱4,140,000 100% ₱2,265,000 100%

liabilities
accounts payable ₱1,530,000 37% ₱701,000 31%
notes payable ₱1,700,000 41% ₱789,000 35%
total liabilities ₱3,230,000 78% ₱1,490,000 66%

equity
common stock ₱600,000 14% ₱550,000 24%
retained earnings ₱310,000 7% ₱225,000 10%
total equity ₱910,000 22% ₱775,000 34%
total liabilities and equity ₱4,140,000 100% ₱2,265,000 100%

Closer Look

Vertical Analysis of Currents

To compute the percentage of Company ABC’s current assets, divide
₱2,315,000 by the total assets ₱4,140,000, then multiply by 100:

The results show that in 2016, the current assets comprised 56% of the total assets, while
46% for 2015. This may indicate that there is more cash within the enterprise and more
liquid assets ready to be converted to cash.

The total liabilities, on the other hand, were 78% for 2016 and 66% for 2015. This may imply
that Company ABC acquired more credit in 2016 to keep the business operating.

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Unit 2: Financial Statement: A Review

Check Your Progress

Perform a vertical analysis on the given balance sheet from XYZ

Convenience Store. Write your answers in the blank spaces provided.

XYZ Convenience Store

Balance Sheet
for the Year Ended December 31, 2018

assets

current assets ₱3,060,000 ______________

plant assets ₱2,400,000 ______________

intangible assets ₱45,000 ______________

total assets ₱5,505,000

liabilities

current liabilities 1,033,500 ______________

long-term liabilities 1,462,500 ______________

total liabilities 2,496,000 ______________

equity

common stock 826,200 ______________

retained earnings 2,182,800 ______________

total equity 3,009,000 ______________

total liabilities and equity ₱5,505,000

Advantages and Disadvantages of Vertical Analysis

Vertical analysis expresses the line items in a financial statement as a percentage of the base
figure. The method can be used to compare the financial performance and position of a
company against another company or of one reporting period to another. Like other
methods, the use of vertical analysis has advantages and disadvantages.

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Unit 2: Financial Statement: A Review

Advantages
1. It simplifies the relationship between the financial items and the baseline item by
expressing them as percentages.
2. It is effective in comparing line-by-line two or more companies in the same industry
and in analyzing the current year vis-à-vis the previous years.
3. It helps readers and users understand the structural composition of different
components.

Disadvantages
1. It compares percentages and not absolute values. Thus, accountants or financial
analysts cannot use vertical analysis to make firm decisions.
2. It does not have general standards in interpreting the results and ratio. The utility of
results depends on how the organization will use it.
3. It does not provide a precise measure of the liquidity of a company.
4. It does not guarantee quality analysis due to a lack of consistency in the ratio of the
elements.

Check Your Progress

Given the advantages and disadvantages in conducting vertical analysis,

how can financial managers use it to help their companies?
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Unit 2: Financial Statement: A Review

Keep in Mind

● Business managers and financial analysts analyze financial statements from all angles
and directions to generate a clear picture of a company’s position and performance.
The most common methods used are vertical and horizontal analyses.
● Vertical analysis is a method that compares a line item against a base item within the
same reporting period. The results are expressed as a percentage of the base amount.
It shows the relative contribution of an account to the overall performance.
● The step-by-step procedure in performing vertical analysis is as follows:

● To compute the percentage of each element of the financial statement against the base
item, the following formula is used:

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Unit 2: Financial Statement: A Review

Try This
A. Short-Answer Response (Identification). Write the correct answer on the provided
space before each number.

_______________ 1. What is the other term used to pertain to vertical analysis?

_______________ 2. What item is assigned as the base amount when performing a

vertical analysis on an income statement?

_______________ 3. What item is assigned as the base amount when performing a

vertical analysis on a balance sheet?

_______________ 4. What financial-analysis techniques are used to express a line

item as a percentage of a base amount?

_______________ 5. Vertical analysis indicates how an item contributes to the overall

performance in the same period. Is vertical analysis static or
dynamic?

B. True or False. Write true if the statement is correct. Otherwise, write false.

_______________ 1. Only the creditors use the financial statement analysis.

_______________ 2. Vertical analysis is the only method in financial statement

analysis that you can use.

_______________ 3. Common-size means that companies with the same number of

employees or workers are comparable.

_______________ 4. Vertical analysis provides an overview of financial performance

and is not useful in some types of decision-making.

_______________ 5. Vertical analysis cannot be used in comparing a company’s

performance for two or more years.

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Unit 2: Financial Statement: A Review

Practice Your Skills

The Bottom Line

Perform a vertical analysis on the income statement of two companies. Use the results of
your analysis to answer the questions concisely.

Company ABC Company DEF

net sales ____________ ₱30,000,000 ____________

₱30,000,000

cost of goods sold ₱13,934,000 ____________ ₱12,839,700 ____________

gross margin ₱16,066,000 ____________ ₱17,160,300 ____________

operating expenses ₱12,450,300 ____________ ₱11,903,450 ____________

net profit ₱3,615,700 ____________ ₱5,256,850 ____________

1. Before performing the vertical analysis, what does the data tell us about the two
companies’ net profit?
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2. After performing the vertical analysis, describe the companies’ net profit. How did
the cost of goods sold affect the gross profit?
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Unit 2: Financial Statement: A Review

3. Similar to the prior question, how did the expenses affect the net profit?
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4. Assume that you were hired as the financial manager of Company ABC. What
strategies would you advise the management to improve the net income of the firm?
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5. It was not mentioned if the companies are of the same business industry. Is it right to
make conclusions for the two companies using vertical analysis? Why or why not?
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Challenge Yourself

Answer the following questions concisely.

1. You performed a vertical analysis in the income statement provided by ABC Clothing
Ltd., and two periods were presented. During year 1, the cost of goods sold
comprised 55% of the total sales, while in year 2, the same account title comprised
67% of the total sales. What advice would you give to the ABC Clothing Ltd. owner?
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Unit 2: Financial Statement: A Review

2. You are an accounting intern in a merchandising company. The financial manager

asked you to analyze the company’s income statements from the year 2018 to 2020.
He/She specifically instructed you to use the easiest way to understand the result.
What tool would you use for this task? Explain your answer.
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3. Can vertical analysis be performed on other financial statements, like statement of

cash flows? Explain your answer.
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Photo Credit
Guangzhou-street-crossing-0549.jpg by Free Software Foundation is licensed under CC
BY-SA 3.0 via Wikimedia Commons.

Bibliography
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2016.
https://www.dummies.com/business/accounting/horizontal-and-vertical-analysis/.

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2021. https://www.accountingtools.com/articles/2017/5/17/vertical-analysis.

DeSimone, Denise, and Marianne Reid Anderson. “Reading Financial Statements to Aid
Business Decision-Making.” IndustriusCFO, A C-Leveled Company, 2015.

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Unit 2: Financial Statement: A Review

https://www.clarion.edu/sbdc/resources/sbdc-resources-forms/2015-09-18ReadingFi
nancialStatements.pdf.

Franklin, Mitchell, Patty Graybeal, and Dixon Cooper. “Financial Statement Analysis.”
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Lakada, Maharani Nadia, S.L.H.V.J. Lapian, and Joan Tumiwa. “Analyzing the Financial
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https://corporatefinanceinstitute.com/resources/knowledge/accounting/vertical-anal
ysis/.

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