Vertical analysis is the term used in the context of accounting where each item of the financial statement is expressed as a percentage of the total of respective statements. Hence, for example, the items of profit and loss account will be expressed as a percentage of sales or items appearing in the asset side of the balance sheet are expressed as a percentage of total assets appearing in the balance sheet. Hence for example if the cash available with the company is $10000 and total assets are $100000 then cash as a percentage of the total asset will be shown as 10 percent if one is doing a vertical analysis. In order to get a better idea about this concept, one should look at some of the advantages and disadvantages of vertical analysis –
Advantages of Vertical Analysis
Simple to Understand
The first and foremost advantage of vertical analysis is that it is very easy to understand and hence anybody having basic mathematics knowledge will be able to grasp this concept as basically this concept is all about expressing the various financial items as a percentage and if you are one of those people who gets paranoid due to confusing figures of balance sheets and profit and loss accounts than vertical analysis can be of great use as one can see the various financial items as a percentage rather than seeing complex figures which makes it easy to interpret the financial statements.
Easy to make Inter Firm Comparison
Another benefit of vertical analysis is that it makes it easy for the company to make comparisons with other companies operating in the same industry. Hence for example suppose the operating expenses of the company as a percentage of profit is 20 percent and operating expenses as a percentage of the profit of the other companies operating in the same industry is 10 percent then it can be of great help as the company can concentrate on reducing the operating expenses thus improving the net profit of the company. In simple words by making a comparison with other companies through vertical analysis company can easily find the problem areas and work upon them to improve the overall performance of the company.
Helps in Comparison with Past Performance
Another advantage of vertical analysis is that it helps the company in comparing the present performance with past performance and find out deviations as well as reasons for such deviations resulting in an improvement in the performance of the company. Hence for example if the operating expenses as a percentage of total profit over the past 5 years is between 15 to 20 percent and in the current year the operating expenses as a percentage of total profit is close to 30 percent then it is a cause of concern and it requires management intervention to check the reasons for such an increase in operating expenses.
Disadvantages of Vertical Analysis
Not a Complete Solution
The biggest disadvantage of vertical analysis is that it is not a complete solution in the sense that while it does show the various items as a percentage of the total but it does not show the reason behind those items having a particular percentage. Hence for example if the profit and loss account is showing operating expenses as 20 percent of total profit then although it’s showing the percentage but it is not telling how much of that operating expenses have incurred due to some unforeseen circumstances or due to some other reason which in turn sometimes can be misleading resulting in wrong decision being taken due to vertical analysis.
Vertical Analysis has Limited Use
While it is easy to understand vertical analysis but this analysis is not used as widely as other methods of financial statements. Hence for example companies usually prepare a financial statement as per accounting standards and it is not necessary to do vertical analysis as per accounting standards hence not all companies do vertical analysis thus limiting the use of vertical analysis. In simple words just like in the case of superhero movies the superhero is the central character while others are supporting characters in the same way in the case of accounting balance sheets and financial statements are central to accounting while vertical analysis is like a supporting character.
Lack of Standardization
Another problem with vertical analysis is that there is a lack of standardization in the sense that unlike ratio analysis or standard costing or financial accounting where there are standards that can be compared with however there are no such standards in the case of vertical analysis. Hence for example in the case of current ratio 2:1 is an ideal current ratio and one can easily compare the company’s current ratio with that of the standard ratio and do further analysis.
As one can see from the above that vertical analysis has pros as well as cons and that is the reason why any company thinking of using vertical analysis should carefully read the above points and then only should take any decision regarding the application of vertical analysis in the company.