# How to Interpret the Vertical Analysis of a Balance Sheet and Profit and Loss

by Cynthia Hartman

Vertical analysis of financial statements uses the common-size format, which sets each financial statement line item as a percent of a baseline number. The name "vertical" describes the process of setting each number as a percent of net sales on the income statement, and of either total assets or total liabilities on the balance sheet. This makes a company's financial statements easily comparable to any other company, and also makes changes or trends over time in one company's financial history easier to spot.

Enter financial statement data into a spreadsheet program. For the income statement, each line item is divided by net sales. For example, start by dividing net sales by net sales, giving you a result of one. Format this as a percentage, and it becomes 100 percent. Calculate every other number down the income statement as a percent of sales. Repeat this process for the balance sheet information, by calculating each asset as a percent of total assets, and each liability as a percent of total liabilities.

Compare prior periods of the same company's data, in the common-size format, against your original data. Choose an account, and read across the years, looking for unusual growth or fluctuations. For example, three years' worth of common-size income statement data may reveal that postage expense as a percent of sales has grown astronomically, or that the company has doubled its political contributions this year, as a percent of sales.

Compare financial data from competitors or average financial statement figures for an industry to provide a benchmark for your subject company. For example, a publication from Robert Morris Associates, "Financial Statement Studies," shows common-size statements by industry group. This book is available at public libraries.

Identify unusual items on the income statement and compare them, line by line, against industry norms. For example, executive compensation tends to run at a certain percentage of sales across different companies, depending on the industry or company size. Check to see that the company's cost of goods sold as a percent of sales, also known as its gross margin, falls within the norm for its industry. Compare the company's net margin, or net income as a percent of sales, against its individual competitors and its industry.

Review the balance sheet with a critical eye. Use two or more periods of historical data on the subject company, and look for items such as increasing levels of debt with no explanation, continually decreasing cash or other current asset balances as a percent of total assets, or any other trends that are not easily explained. Additionally, check common-size statistics for the subject company's industry to verify information such as whether its debt and equity levels over time fall within the normal range of its peers.

### Tips

• Keep in mind that more detail provides more opportunities to fine-tune your analysis and discover trends or outliers over time. Conversely, performing the analysis with a higher-level set of numbers makes it easier to quickly spot overall growth and spending trends for the company.