chapter03 - Confirming Pages Financial Statements Analysis...

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3 C H A P T E R Financial Statements Analysis and Long-Term Planning 3 . 1 F I N A N C I A L S TAT E M E N T S A N A LY S I S In Chapter 2, we discussed some of the essential concepts of financial statements and cash flows. This chapter continues where our earlier discussion left off. Our goal here is to expand your understanding of the uses (and abuses) of financial statement information. A good working knowledge of financial statements is desirable simply because such statements, and numbers derived from those statements, are the primary means of com- municating financial information both within the firm and outside the firm. In short, much of the language of business finance is rooted in the ideas we discuss in this chapter. Clearly, one important goal of the accountant is to report financial information to the user in a form useful for decision making. Ironically, the information frequently does not come to the user in such a form. In other words, financial statements don’t come with a user’s guide. This chapter is a first step in filling this gap. Standardizing Statements One obvious thing we might want to do with a company’s financial statements is to compare them to those of other, similar companies. We would immediately have a O P E N I N G C A S E O n April 3, 2008, the price of a share of common stock in hotel company Marriott, Inc., closed at about $36. At that price, Marriott had a price–earnings (PE) ratio of 21. That is, investors were willing to pay $21 for every dollar in income earned by Marriott. At the same time, investors were willing to pay $67, $32, and $12 for each dollar earned by Amazon.com, Apple, and Bank of America, respectively. At the other extreme were XM Satellite Radio and Sirius Satellite Radio, both relative newcomers to the stock market. Each had negative earnings for the previous year, yet XM was priced at about $12 per share and Sirius at about $3 per share. Because they had negative earnings, their PE ratios would have been negative, so they were not reported. At that time, the typical stock in the S&P 500 index of large company stocks was trading at a PE of about 19, or about 19 times earnings, as they say on Wall Street. What do PE ratios tell us and why are they important? To find out, this chapter explores a variety of ratios and their use in financial analysis and planning.
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PART 1 Overview 46 problem, however. It’s almost impossible to directly compare the financial statements for two companies because of differences in size. For example, Ford and GM are obviously serious rivals in the auto market, but the two companies are not the same size, so it is difficult to compare them directly. For that matter, it’s difficult to even compare financial statements from different points in time for the same company if the company’s size has changed. The size problem is compounded if we try to compare GM and, say, Toyota. If Toyota’s financial statements are denomi- nated in yen, then we have a size and a currency difference.
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