Are you spending too much on paper goods? Is rent too big a proportion of your income? Vertical Analysis may have the answers.
Vertical Analysis of a financial statement is a reporting trick that will help you see where you’re money is going – and compare your numbers to industry standards.
It’s done by converting the dollar amounts on your financial statement to percentages, so you’re assessing your significant financial expenses in relation to one constant variable, such as net sales on an income statement.
Knowing you’re spending $15,000 a month on food costs is important, but knowing that this represents 55% of your net sales is much more powerful. You can track that number over time and compare it to industry benchmarks. You can even set parameters that will serve as an early warning sign of something going wrong: say, food costs getting too high. If sales are going up too, you might just assume that growing food costs are part of the deal – but what if those costs are outpacing your revenue growth? With vertical analysis you’ll see the change occurring.
So, how does it work?
We’ve heard that a lot of business owners find the advice in this regard is a little abstract, so i’m going to provide a pretty detailed walk through here:
To find the percentage of any item on your income statement, you would divide the dollar amount of that item by the dollar amount of net sales. For example, if your net sales for last month equaled $150,000 and your rent was $3000, you would divide 3000 by 150,000 and multiply by 100 to get a percentage. Now you know that your rent expense made up 2 percent of your net sales last month. You can then compare that to the standard in your industry. Here is the equation:
( $ Item Amount / $ Net Sales ) x 100 = Item Percentage %
In a spreadsheet, once you identify the constant variable, a simple drag-and-copy will give you all the line-item percentages on your income statement. (In Microsoft Excel you would add dollar signs before the cell character that you designate as constant – for example, if the cell B5 contained the dollar figure for net sales, you would use $B$5 as your divisor for all other line items.)
While the term “constant variable” sounds contradictory, it is a common math term that means you have assigned a definite value to a selected variable. Once you have done this, the value never changes so it remains “constant.” In the case of vertical analysis, the percent value of net sales remains the same – i.e. 100, which is what you get when you divide the amount of net sales by itself – even if the dollar numbers change dramatically from one period to another. This is what reveals the important ratios that make up the financial part of your business. They show you just how successful your business is currently, and what potential it has to become even better in the future.
While it is easy to convert dollar amounts into percentages in a spreadsheet program such as Excel, not every accounting program offers vertical analysis as an option in the list of reports. This is unfortunate, but it just means you will need to export information from your accounting program into a spreadsheet program and go from there. It is not difficult once you get a little practice.
The following are some important tips that vertical analysis of an income statement can reveal to you. Please note that the definition of “net sales” means total sales (at the very top of your income statement) minus returns, discounts and allowances.
How to compare your operating expenses and profit margin compares to other businesses in your industry.
You can gain valuable clues into how your business currently measures up to industry standards. For example, it may be difficult to operate a successful restaurant if your food costs are much higher than 30 percent of net sales or if your direct labor costs are higher than 35 percent. Together, these make up what’s known as “prime cost” and this figure generally needs to stay under the 60 to 65 percent range for a restaurant to be profitable. Certainly there are exceptions to any rule, and a great deal of variation in the way individuals manage their operations, but using vertical analysis is a quick way to find out how far above or below the standard your business falls within your industry or category.
How to price your products and services more accurately.
If you want to achieve the profit margin necessary to make your business successful, you need to pay close attention to pricing and markup formulas. For example, if you operate a retail store, and you see on your annual income statement that your combined operating expenses, including administrative, marketing and overhead, totaled 35 percent of net sales, and your operating income was 20 percent, how would you price a new product that cost you $30 to buy at wholesale based on that information?
You might use the pricing formula expressed as R = C/(1-G). This translates to “Revenue (or selling price) equals Cost (of product) divided by 1-Gross Margin.” The term “gross margin” means what is left when you subtract cost of goods sold from net sales on your income statement. But it also equals your operating expenses (fixed costs) plus profit, because this is how the accounting equation works. In this case, $30 would be divided by 45 percent (one minus 55 percent) to yield your required markup of around 122 percent. Using this formula, you would price your product somewhere around $67.
Pricing strategies can be a lot more complex (or a lot more simplistic) than this, of course; you might decide this markup is too high or too low or you might need to use a different formula altogether. However, no formula or strategy will be accurate without first doing a vertical analysis of your revenue, costs, expenses and profit.
How to compare different expense and cost ratios to one another.
Comparing different expense ratios allows you to direct your cost saving efforts where it will have the most impact. For example, suppose you have been spending a lot of time trying to cut back on one expense, such as insurance. Through vertical analysis you find out this expense takes up a relatively low 2 percent of net sales, but your electricity and gas is costing you 15 percent. Perhaps your efforts would be better spent on reigning in energy costs instead.
If you have one expense that makes up 4.5 percent of your net sales, and another expense that makes up 15 percent, which is better, cutting the lower cost by 60 percent or cutting the higher costs by 25 percent? This can be easily demonstrated in a spreadsheet. You will save more money by cutting the greater expense by 25 percent than a 60 percent reduction in your smaller expense. Of course it would be great to be able to do both, but an entrepreneur’s time is limited and investments of time, effort and money should yield the best results possible. Paying attention to vertical analysis might be the ticket to higher profits and greater success.
How to quickly spot trouble areas so you can investigate what is going wrong and why.
If you discover that a certain cost has skyrocketed in recent months, it may be a sign that theft or fraud is taking place either within your business or from one of your vendors. While you could simply compare the dollar amounts from one month to the next, sometimes net sales and profit margins can go up as well, and the general increase in “good” numbers may offset the increase in “bad” numbers, especially if you are very busy and only giving your income statement a quick glance. Dollar amounts can be deceptive, but vertical analysis will show these discrepancies quickly. When an expense jumps from a typical 4 percent to 7.8 percent, that is nearly doubling, and this red flag needs some attention.
It is time to get better acquainted with vertical analysis, as it can be very useful for the small business owner. Don’t let the mathematical-sounding term discourage you from performing this essential task. Nothing is more important than understanding how your business is really doing at its financial core. Simple spreadsheet functions make it easier than ever, and a little time and effort is all you need to make better and wiser business decisions. If you have questions about how a point of sale can help provide access to this data, make sure to give one of our Point of Sale Specialists a call today on 800-820-9814.