Why is a Vertical Analysis of a Company's Financial Statements More Important than the Company's Value?

Most people who read a company valuation report go directly to the bottom line - the line of the company's value. Although whether the company is worth $100,000, $200,000, or a million is very important, it is not the most critical question.

The reason is that if you hire two appraisers to estimate the value of the same company - we will most likely get two different values. One can estimate the company's value at $100,000 and the other at $200,000. The reason for the two possible values is the various assumptions the appraiser can adopt to perform the valuation. 

This is why it is more important than the company's value - several other financial analyses you can find in the valuation report. We have discussed 12 financial analyses you can see in the valuation report of Equitest - here.

In this blog post, we will discuss why a vertical analysis of a company's financial statements is more important than the value of the company itself. 

Vertical Analysis

Vertical analysis is a financial analysis performed on the firm's financial statements. As part of this analysis, each section in the profit and loss report is divided by sales. Then a similar analysis is performed for the firm's balance sheet when each section of the balance sheet is divided by the total assets. The goal is to find what percentage of sales or assets each section makes up.

Example of Vertical Analysis of Balance Sheet

We will illustrate a vertical analysis of the balance sheet using the following example:

Given a company that has the following assets:

Her cash is worth $100,

The debtor's section amounts to $200,

The inventory equals $300, 

and the fixed assets equal $400.

As part of the vertical analysis of the balance sheet, each section is divided into total assets.

The total assets in the example equals $1,000 (100 + 200 + 300 + 400).

The result will be: the cash equals 10% of the assets, the debtors to 20%, the inventory to 30%, and the fixed assets to 40%.

How are the Results of the Vertical Analysis of the Balance Sheet Analyzed?

These percentages do not tell us much. But if we compare them given the nature of the company's activity, we can learn a lot. We can examine fixed asset composition and compare it to other similar companies if it is a manufacturing company.

If, for example - similar companies (other companies in the industry) own fixed assets at a rate of about 50% of the assets, we need to check what this means for our company.

It may be that the company's fixed assets, such as the machines, consist of old equipment and devices.

In that case, we should be worried. We have machines, which today produce products and generate income for the company. But the big question is how long will they be able to continue to develop the same income before they die?

On the other hand, it could be that the reason for the relatively low part of fixed assets in total assets is that our company is more efficient. It uses technology to generate the same income but less investment in fixed assets. In this case, the company's situation is excellent because it is more profitable.

The reason can be discovered through a vertical analysis of the profit and loss statement.

An Example of Vertical Analysis of the Profit and Loss Statement

Let's assume that a company's sales are worth 2000 dollars, the expenses are 1500 dollars, and therefore the profit is 500 dollars.

In the vertical analysis of the profit and loss statement, each section is divided into sales.

In our example - the sales are equal to 100%, the expenses to 75% (2,000 / 1,500), and the profit to 25%.

How are the Vertical Analysis Results Analyzed for the Profit and Loss Statement?

The results of the vertical analysis for the profit and loss report are very similar to the vertical analysis for the balance sheet. That is, by comparing it to other companies.

If one company in the industry earns 10%, our situation is excellent - because the company is more profitable.

If, on the other hand, another company in the industry earns 30%, our situation is worse because the company is less profitable.

Combining the vertical analysis for the balance sheet with the vertical analysis for the profit and loss statement allows for brilliant insights. In the vertical analysis of the balance sheet, we presented two possible meanings - one positive and the other negative, resulting in a company's fixed assets accounting for 40%, while in the industry - 50%.

Only a combination of a vertical analysis for the profit and loss statement with a vertical analysis for the balance sheet will make it possible to understand the true meaning of the result.

If the company is more profitable than the industry and it has fewer fixed assets. The company probably uses better technology.

Why can a vertical analysis of the balance sheet and profit and loss report teach more than the company's value?

The result of the valuation depends on the assumptions used for the valuation. Therefore two appraisers can reach two different results. On the other hand, vertical analysis can be performed in one way. The analysis of the analysis results is less sensitive to the meanings. That is, it is more challenging to play with the interpretation of the results.

For this reason, we have integrated, as an integral part of Equitest's valuation report, vertical analysis for the balance sheet and the profit and loss statement.

Conclusion

In this blog post we discussed why vertical analysis is important at least as the value of a company.

Suppose you look for a straightforward way to evaluate your business, manage your cap table, or create a pitch deck. In that case, you can try our intuitive ai based business valuation software or our business valuation calculator, or you can contact us for free advice or schedule a demo.