Vertical Analysis of the Income Statement

Don't we all just love analyzing stuff? We analyze everything around us, from that cool new gadget we can't wait to get our hands on, to the latest movie we watched, to the new store that just opened up in town. We have to analyze it all before we decide to invest in it, right?

And why not put those analytical skills to good use when it comes to investing in a company? By utilizing techniques such as Vertical Analysis and its counterpart, Horizontal Analysis, we can gain an understanding of a company's business before we make any investment.

Learn the art of Vertical Analysis

Before we get into Vertical Analysis and how to do it, remember that to do it, you need to choose a base. For an Income statement, which is also called a Profit & Loss Account, we use Sales as the base.

Vertical analysis is a way to analyze financial statements. It shows each item as a percentage of a base figure. It is easy to understand. In this type of analysis, all income statement items are shown as a percentage of Sales.

The Income Statement of a company begins with Revenue, followed by the deduction of Cost of Goods Sold, which represents the direct costs of producing goods sold by the company, to get Gross Profit.

If we then deduct the indirect expenses from the Gross Profit, we get Operating Profit, also known as EBIT.

Finally, if we subtract the interest and taxes from Operating Income, we get Net Income.

In short,

Gross Profit= Revenue - COGS
Operating Profit = Gross Profit - Indirect expenses
Net Profit = Operating Profit - Interest & Taxes

You can perform vertical analysis to study each item on the Income statement. In this article, we will focus on Gross Profit Margin, Operating Profit Margin, and Net Profit Margin. And just like we said before, we need a base to do this analysis, and that base is Sales. All these three ratios come under Profitability ratios.

1) Gross Profit Margin

This ratio shows us how much money is left over after covering the cost of goods sold for every buck earned. The higher the ratio, the better it is for the Company. Companies can use this ratio to identify areas for improvement, such as reducing expenses and/or enhancing sales.

Gross Profit Margin = Revenue - COGS/Sales or Gross Profit/Sales

2) Operating Profit Margin

The operating margin is a way to measure how much money a company makes after they've paid for costs like wages and raw materials, but before they pay any interest or taxes. Operating profit is the money that remains to pay back loans and taxes to the government. The more percentage, the more profitable the business.

Operating Profit Margin = Earnings before Interest and Taxes (EBIT)/Sales

If you are a salaried employee, think of Operating Profit as the money left from your salary that you can use to pay for your EMIs and taxes.

3) Net Profit Margin

Net Profit is the last item on the Income statement. Net Profit Margin is a way to figure out how much profit a company makes from all the money it earns. It's a percentage that shows how much money is left over after all the expenses are paid.

Net Profit Margin = Net Profit/Sales

The net profit of a company is like the savings of an individual. Let's take the example of Arjun, who earns Rs.1 lakh per month. After paying off all his expenses, he manages to save a sum of Rs.20,000. That means his net profit margin is 20%.

After we calculate these ratios, we can perform an analysis of the current percentages against previous periods to determine whether the ratios have improved or declined. We can also utilize these ratios to compare the ratios of one company with those of its peers.