Vertical analysis

What it means

Vertical analysis is a financial analysis method in which each line of a statement is expressed as a percentage of a chosen total. In the income statement the base is usually revenue; in the balance sheet, total assets or total liabilities and equity.

The result is a common-size statement showing what the company is made of: for instance, that materials make up 45 per cent of revenue, wages 25 per cent and profit 8 per cent, or that inventory accounts for a third of assets. It answers the question of structure rather than absolute size.

Vertical analysis is often combined with horizontal analysis, which tracks changes in items over time. Together they show how the structure of costs and assets shifts from year to year and form the basis for more detailed financial ratios.

How it works in practice

In our annual overview for clients, we present the income statement as percentages of revenue for the last three years. Management can immediately see which cost line is growing faster than revenue and where margins are shrinking, without doing the maths themselves.

Comparability is the big advantage. Percentages allow a small company to be compared with larger competitors or the industry average through benchmarking. If competitors’ staff costs are 20 per cent of revenue and the client’s are 30, that warrants a closer look.

On the balance sheet, vertical analysis helps assess the financing structure: what share of liabilities and equity is equity and what is borrowed, and whether assets are tied up mainly in fixed assets or in inventory and receivables. This picture is useful when negotiating with a bank.

What to watch out for

Percentages can mislead when the base changes. If revenue drops sharply, the share of fixed costs jumps even though their absolute amount is unchanged. Vertical analysis should therefore always be read alongside absolute figures and their trend.

When comparing with other companies, allow for differences in accounting methods and business models. A company that outsources work will have low wages and high service costs, another the reverse. A different structure does not necessarily mean different efficiency.