Deals & Acquisitions
Feb 20, 2023
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This guide explains what vertical analysis is, why it’s important, and it goes into detail about the percentages and ratios that result from doing vertical analysis. Here are some key takeaways about vertical analysis:
Vertical analysis is when we take an income statement, and we take each component of that income statement (ie. cost of goods sold, research & development, etc.) and we divide it into revenue to get a percentage.
We do this for purposes of comparison. Vertical analysis takes hard financial information and transforms it into meaningful percentages.
Vertical analysis helps us understand our numbers. It’s extremely useful for businesses to use internally, as well as for financial analysts.
Internally, a company would use vertical analysis to help judge its performance over the given accounting period. With vertical analysis they can see how each line item on the income statement relates to another (usually revenue). The idea here is that we can see a percentage of how much each expense contributes to revenue. So out of every dollar in revenue that is earned, how many cents go to the cost of goods sold? How many cents go to administrative expenses?
This information could then be taken and compared to previous months, quarters, or years to identify trends (horizontal analysis). For example, they might realize their cost of goods sold has risen compared to past years. Vertical analysis attempts to make financial information useful, so it can be used for comparison purposes.
When analyzing a company, financial analysts use vertical analysis in the same way in order to understand how a business is performing. Analysts are usually more interested in vertical analysis as a way to help understand a business for valuation purposes. For example, they can compare a company’s gross profit margins with its competitors to see how it measures up in its market. This is a process called benchmarking.
Vertical analysis can be used for more than gross profit, it can be used for every single component of the income statement. Vertical analysis gives us a percentage that can be used for comparison purposes.
Now that we understand what vertical analysis is, we’ll look at it through an example so we can see why it’s useful. Here, we’ll look at gross profit margins.
As an example, we get our gross profit from taking revenue and subtracting cost of goods sold (or cost of sales). With vertical analysis, we turn gross profit into a meaningful percentage by dividing it into revenue. This gives us our gross profit margin—which is a percentage.
So, if we have revenue of $10 million and cost of goods sold of $3 million, then our gross profit is $7 million (Gross Profit = Rev - CoGS). Vertical analysis is when we take these financial components and transform them into meaningful ratios and percentages. If we divide $7 million into $10 million, we arrive at our gross profit margin of 70 percent.
Percentages are useful because we understand them better than raw numbers. If you heard that a company had gross profit of $7 million, what does that mean? Is it good or bad? Obviously, having gross profit of $7 million is much better if the company did $10 million in top line revenue, versus $100 million.
With vertical analysis, we can see a percentage, which is much more useful than the numbers themselves. This is especially the case when we’re trying to benchmark performance against competitive businesses. If one business had gross profit of $7 million, and their competitor had gross profit of $12 million, just by those numbers alone we might assume the competitor is doing better. But, if we find out that that competitor has gross profit margins of 20 percent compared to our 70 percent, we see a different picture.
The essence of vertical analysis is that we’re taking the hard financials and making sense of them. We want to be able to understand how much expense contributes to a portion of revenue.
Now that we understand what vertical analysis is and why it’s useful, we’ll look at what we can learn from vertical analysis.
As stated above, we can use vertical analysis to take every component of the income statement and divide it into revenue.
The most common things that analysts look for with vertical analysis are:
That said, we can also use vertical analysis to see what percentage of revenue goes into research and development, personnel costs, selling costs, etc.
This is useful so that we can compare performance to the company’s previous years (horizontal analysis) or against competitors (benchmarking).
We want to use vertical analysis to understand how much each expense contributes to a portion of revenue.
