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Unformatted text preview: I n March 2005, shares of stock in chipmaker Intel were trad-ing for about $23. At that price, Intel had a price-earnings ratio of 20, meaning that investors were willing to pay $20 for every dollar in income earned by Intel. At the same time, in-vestors were willing to pay a stunning $752 for each dollar earned by Computer Associates but only about $11 and $6 for each dollar earned by Whirlpool and Ford, respectively. And there were stocks like XM Satellite Radio, which, despite having no earnings (a loss actually), had a stock price of about $30 per share. Meanwhile, the average stock in the Standard and Poor’s (S&P) 500 index, which contains 500 of the largest publicly traded companies in the United States, had a PE ratio of 20, so Intel was about average in this regard. As we look at these numbers, an obvious question arises: Why were investors willing to pay so much for a dollar of Com-puter Associates’ earnings and so much less for a dollar earned by Ford? To understand the answer, we need to delve into subjects such as relative profitability and growth potential, and we also need to know how to compare financial and oper-ating information across companies. By a remarkable coinci-dence, that is precisely what this chapter is about. The PE ratio is just one example of a financial ratio. As we will see in this chapter, there are a wide variety of such ratios, all designed to summarize specific aspects of a firm’s financial position. In addition to discussing financial ratios and what they mean, we will have quite a bit to say about who uses this infor-mation and why. 3 Working with Financial Statements THE MOST IMPORTANT THING TO CARRY AWAY FROM THIS CHAPTER IS A GOOD UNDERSTANDING OF: ■ How to standardize financial statements for comparison purposes. ■ How to compute and, more importantly, interpret some common ratios. ■ The determinants of a firm’s profitability and growth. ■ Some of the problems and pitfalls in financial statement analysis. ross46733_ch03.qxd 7/8/05 07:23 PM Page 47 Everybody needs to understand ratios. Managers will find that almost every business characteristic, from profitability to employee productivity, is summarized in some kind of ratio. Marketers examine ratios dealing with costs, markups, and margins. Production personnel focus on ratios dealing with issues such as operating efficiency. Accountants need to under-stand ratios because, among other things, ratios are one of the most common and important forms of financial statement information. In fact, regardless of your field, you may very well find that your compensation is tied to some ratio or group of ratios. Perhaps that is the best reason to study up!...
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This note was uploaded on 08/18/2010 for the course ACCOUNTING Fin 101 taught by Professor Johnson during the Fall '10 term at DeVry Fresno.
- Fall '10
- The Land