AI Finance Use Cases - Part 1: Vertical Analysis

AI Finance Use Cases - Part 1: Vertical Analysis

Non-finance managers and executives often struggle with financial analysis. It is very rare that these managers get a formal education in finance. Such components are typically part of an Executive MBA program. However, even executive MBAs provide very high-level financial advice and sometimes overlook simple and straightforward concepts.

In this series of articles, we will use generative AI to do financial analysis for us. We will go from very simple concepts to more advanced ones. This series will explore the depth and breadth of financial analysis using generative AI.

Disclaimer: we are not financial experts. This series aims to empower non-financial managers with AI tools, not to replace financial professionals.

To begin our exploration, we first set up our AI with a specific persona.

System Prompt

We start with a system prompt to define the desired AI personality. We have defined the role as:

You are a CFO with 20 years experience in financial analytics.

Vertical Analysis

If you have never heard the term vertical analysis, you may be puzzled by it. As many areas in business, finance has a lot of jargon that can be difficult to comprehend, even when the concept is simple. Let’s start by asking our expert about vertical analysis.

Prompt 1: Definition

What is vertical analysis?

Answer

Vertical analysis is a method of financial statement analysis in which each line item on a financial statement is listed as a percentage of another item. Typically, this technique is used on an income statement, where every line item is stated as a percentage of gross sales, or on a balance sheet, where every item is expressed as a percentage of total assets or total liabilities.

This method is useful for understanding the relative proportions of accounts within a financial statement and for making comparisons either over time within the same company or across different companies, regardless of size. Vertical analysis helps to identify trends and evaluate the financial health and performance efficiency of a company by showing the relative significance of each line item in terms of its contribution to revenue or resource allocation.

Prompt 2: Example

Because we set-up the AI assistant to be an expert with 20 years experience, it is giving a detailed and technical explanation. It will be good to ask for an example to better understand.

Give me an example of vertical analysis.

Answer

Certainly! Let’s consider a simple example of vertical analysis using a hypothetical company’s income statement.

Suppose the income statement for XYZ Company for the year 2022 is as follows:

• Revenue: $500,000
• Cost of Goods Sold (COGS): $300,000
• Gross Profit: $200,000 (Revenue - COGS)
• Operating Expenses: $100,000
• Net Income: $100,000 (Gross Profit - Operating Expenses)

To perform a vertical analysis, we would convert each of these amounts into a percentage of total revenue. Here’s how it would look:

• Revenue: $500,000 (100% of revenue, since revenue is the base figure)
• Cost of Goods Sold (COGS): $300,000 (60% of revenue, calculated as $300,000 / $500,000 * 100)
• Gross Profit: $200,000 (40% of revenue, calculated as $200,000 / $500,000 * 100)
• Operating Expenses: $100,000 (20% of revenue, calculated as $100,000 / $500,000 * 100)
• Net Income: $100,000 (20% of revenue, calculated as $100,000 / $500,000 * 100)

This vertical analysis allows stakeholders to see the proportion of each item relative to total revenue. For instance, it shows that COGS consumes 60% of the revenue, which might be a point of focus for cost reduction efforts. Similarly, seeing that net income is 20% of revenue provides a quick snapshot of profitability. This type of analysis is particularly useful for comparing financial statements of companies of different sizes, as it normalizes the figures by expressing them as percentages.

Prompt 3: Our Numbers

Now that we have a good understanding of the principles, and a made up example to understand how it works, we can run it on our numbers. We are using different terms here for our income statement, then the one used in the example:

• We separated Labor Cost and COGS,
• We use Overhead instead of Operating Expenses,
• We don’t provide the Net Profit, instead of giving the Net Income.

The Finance jargon has different names for very similar concepts. Your LLM can also help you to understand the difference between names, identify synonyms, and dig deeper into these concepts. For this prompt, we just can see the flexibility of the LLM to our own vocabulary. The answer is using exactly the terms we are using.

Compute the net profit and perform a vertical analysis of the company with the following income statement: Revenue $1m, COGS $50k, Labor Cost $250k, Overhead $500k.

Answer

First, let’s compute the Net Profit for the company:

• Revenue: $1,000,000
• Cost of Goods Sold (COGS): $50,000
• Labor Cost: $250,000
• Overhead: $500,000

Total Expenses = COGS + Labor Cost + Overhead = $50,000 + $250,000 + $500,000 = $800,000 Net Profit = Revenue - Total Expenses = $1,000,000 - $800,000 = $200,000

Now, let’s perform a vertical analysis, where each item is expressed as a percentage of total revenue:

• Revenue: $1,000,000 (100% of revenue)
• COGS: $50,000 (5% of revenue, calculated as $50,000 / $1,000,000 * 100)
• Labor Cost: $250,000 (25% of revenue, calculated as $250,000 / $1,000,000 * 100)
• Overhead: $500,000 (50% of revenue, calculated as $500,000 / $1,000,000 * 100)
• Net Profit: $200,000 (20% of revenue, calculated as $200,000 / $1,000,000 * 100)

This vertical analysis provides a clear view of how each component of the income statement relates to the total revenue. For instance, it highlights that overhead is a significant cost, consuming 50% of the revenue, which might be an area to investigate for potential cost savings. Additionally, the net profit margin of 20% gives an insight into the profitability of the company.

What If Scenarios

Computing the financial impact of changes is a difficult tasks. Still looking at an income statement, we can leverage LLM to compute for us the impact of incremental changes. This technical is sometimes called the power of 1 . A change in 1% in a financial dimension of a business can have a leverage effect and result in significant impact on the net profit. Let’s try that with our AI financial assistant.

Prompt 4: Power of 1%

Compute the combined impact of a 1% increase in sales, decrease of 1% in COGS and decrease in 1% in overhead for a company this the current income statement: 10m revenue, 5m COGS, 4m G&A. Express the result in net profit percentage.

Answer

To compute the combined impact of a 1% increase in sales, a 1% decrease in COGS, and a 1% decrease in overhead (G&A), we first need to calculate the new values for each of these components:

Revenue:

• Current Revenue = $10,000,000
• Increase by 1% = $10,000,000 * 1.01 = $10,100,000 Cost of Goods Sold (COGS):
• Current COGS = $5,000,000
• Decrease by 1% = $5,000,000 * 0.99 = $4,950,000 General and Administrative Expenses (G&A):
• Current G&A = $4,000,000
• Decrease by 1% = $4,000,000 * 0.99 = $3,960,000

Now, let’s calculate the new Net Profit:

• New Total Expenses = New COGS + New G&A = $4,950,000 + $3,960,000 = $8,910,000
• New Net Profit = New Revenue - New Total Expenses = $10,100,000 - $8,910,000 = $1,190,000

To express the result as a net profit percentage:

• Net Profit Percentage = (New Net Profit / New Revenue) * 100 = ($1,190,000 / $10,100,000) * 100 = 11.78%

Thus, with a 1% increase in sales, a 1% decrease in COGS, and a 1% decrease in overhead, the net profit percentage of the company would be approximately 11.78%. This represents an improvement compared to the original scenario, where the net profit percentage would have been:

• Original Net Profit = Original Revenue - (Original COGS + Original G&A) = $10,000,000 - ($5,000,000 + $4,000,000) = $1,000,000
• Original Net Profit Percentage = ($1,000,000 / $10,000,000) * 100 = 10%

The improvement in net profit percentage from 10% to 11.78% is due to the combined effect of increased sales and reduced costs.

Accuracy & Analysis

The number are correct, but more importantly, the logic is correct. As we have set-up our AI assistant to have 20 year experience in the field, it forces the model to give more information, explain the steps, make comments, and add analysis when necessary.

Ideal for Non-Finance Managers

These few prompts won’t be useful for experience CFO, but can provide great value for non-financial managers. It will:

• Increase there understanding of financial concepts,
• Avoid being lost in the financial jargon, especially multiple names for the same concept,
• Avoid logic mistakes in the processing of financial data,
• Give the ability to further explore analysis perspective,
• Save time on financial “chores”

In Part 2 of our series where delve into financial ratios .

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Technology

The above answers were generated by gpt4-turbo, running on azure infrastructure, using our internal web application.

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