Foundations of Accounting Notes.docx - Section 1 Financial...

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Section 1 Financial Statement Analysis Financial Investments Assume Apple Inc.’s common stock is trading at $125 per share. If you had funds to invest, would you invest in Apple common stock? Apple is a well-known company. However some other well known companies, including United Airlines, Kmart, Polaroid, and Planet Hollywood, share the common characteristic of having once declared bankruptcy! Obviously, being well known is not necessarily a sufficient basis for an investment decision. Knowledge that a company has a good product, by itself, may also be an inadequate basis for investing in the company. Even with a good product, inadequate financing and a variety of other reasons could cause a company to be unprofitable or even go bankrupt. How, then, does one decide upon companies in which to invest? Investors can improve decision making by considering, understanding, and analyzing financial data and other information included in financial statements and corporate reports. The basic financial statements provide information that is useful for making investment and other economic decisions about businesses. Investors can use analytical procedures to examine relations between items included with a single company’s financial statements. Analytical procedures are also widely used to examine financial statement information across time and across companies. Common analytical measures are not ends in themselves, but tools for evaluating financial and operating data. Many other factors, such as industry trends and general economic conditions, can play important roles in making investment decisions. Basic Analytical Procedures: Horizontal Analysis Although financial statement line items can be analyzed as dollar amounts, expressing amounts as percentages can facilitate comparison and interpretation. Analysis of percentage increases and decreases in financial statements items across time is called horizontal analysis . In horizontal analysis, the amount of each line item on the most recent statement is compared with the related item on earlier statements, and expressed as a percentage change. When horizontal analysis is used to compare data from two or more dates or periods, amounts from the earliest statement are used as the base for computing percentage increases and decreases. While computing the percentage change in various financial statement line items is straightforward, interpreting the significance of the increases and decreases usually benefits from additional information. The example below illustrates a horizontal analysis of the current asset section of Grand Company’s balance sheet. Grand Company Comparative Schedule of Current Assets December 31, 20X1 and 20X2
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20X2 20X1 Increase or Amount (Decrease) Percent Cash $90,500 $64,700 $25,800 39.9% Marketable Securities 75,000 60,000 15,000 25.0 Accounts Receivable (net) 115,000 120,000 (5,000) (4.2) Inventories 264,000 283,000 (19,000) (6.7) Prepaid Expenses 5,500 5,500 200 3.8 Total Current Assets $550,000 $533,000 $17,000 3.2% Basic Analytical Procedures: Vertical Analysis Percentage analysis may also be used to show the relationship of each component to the total within a single statement. This type of analysis is called
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