The vertical analysis of an income statement is an effective way to compare different statements by rendering all items on the statement as a percentage of sales. By doing this, business management can compare the statement not only to the performance of previous years but also to its competitors in the market. It is important for those performing a vertical analysis of an income statement to focus on the percentages and not the raw numbers. They should also be on the lookout for big percentage changes from previous years or from their rivals so they can ascertain what areas of the business need improvement.
An income statement is a financial document required of most businesses that shows the net income earned during a particular time period, which is usually one year. The statement amasses all expenses and then subtracts them from all revenues earned during the year. Analyzing this statement is an important part of the business process for those companies who wish to improve on what they have done in the past. Performing a vertical analysis of an income statement has many benefits.
Perhaps the most important part of performing a vertical analysis of an income statement is putting the net sales at the top of the statement and letting all of the percentages be derived from that. As an example, imagine that a company's net sales for a year are $100,000 US Dollars (USD) During that same year, the cost of goods sold is $60,000 USD. That means that the cost of goods sold is 60 percent of net sales, and that percentage should be listed alongside of the cost of goods sold total. Similarly, percentages should be made for interest, tax, administrative, and operational expenses.
With all of these percentages in place, vertical analysis of an income statement continues with simple comparisons between pertinent statements. These statements used for comparing can come from the company in years past, allowing it to see areas of improvement and struggle. In addition, a company should compare the percentages to those companies that are in the same market and are direct competitors.
Finding areas of significant disparity is one of the goals of vertical analysis of an income statement. Financial managers should be on the lookout for why one item is not in line with other statements. As an example, a company that has averaged operational expenses that are 10 percent of net sales in years past should be concerned if that number suddenly jumps to 20 percent in the year being studied. This information can help the company explore areas where things can be done more efficiently, thus improving the bottom line.