Financial Statements and Long-Term Financial Planning
WORKING WITH FINANCIAL
On April 19, 2006, the price of a share of common
stock in Linux software distributor Red Hat, Inc.,
closed at about $30. At that price,
The Wall Street
reported Red Hat had a price–earnings (PE)
ratio of 73. That is, investors were willing to pay $73
for every dollar in income earned by Red Hat. At the
willing to pay
only $24, $20,
and $15 for
Roll, and Harley
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 $23 per share
and Sirius at about $5 per share. Because they had
negative earnings, their PE ratios would have been
negative, so they were not reported. At that time, the
stocks was trading at a PE of about 18, or about 18
times earnings, as they say on Wall Street.
Price-to-earnings comparisons are examples of the
use of fi nancial ratios. As we will see in this chapter,
there are a wide variety of fi nancial ratios, all designed to
summarize specifi c aspects of a fi rm’s fi nancial position.
In addition to discussing how to analyze fi nancial statements
and compute fi nancial ratios, we will have quite a
bit to say about who uses this information and why.
In Chapter 2
, we discussed some of the essential concepts of fi nancial
statements and cash fl ows. Part 2, this chapter and the next, continues
where our earlier discussion left off. Our goal here is to expand your understanding
of the uses (and abuses) of fi nancial statement information.
Financial statement information will crop up in various places in the remainder of our
book. Part 2 is not essential for understanding this material, but it will help give you an
overall perspective on the role of fi nancial statement information in corporate fi nance.
A good working knowledge of fi nancial statements is desirable simply because such
statements, and numbers derived from those statements, are the primary means of communicating
fi nancial information both within the fi rm and outside the fi rm. In short, much
of the language of corporate fi nance is rooted in the ideas we discuss in this chapter.
Furthermore, as we will see, there are many different ways of using fi nancial statement
information and many different types of users. This diversity refl ects the fact that fi nancial
statement information plays an important part in many types of decisions.
In the best of all worlds, the fi nancial manager has full market value information about
all of the fi rm’s assets. This will rarely (if ever) happen. So, the reason we rely on accounting
fi gures for much of our fi nancial information is that we are almost always unable to
obtain all (or even part) of the market information we want. The only meaningful yardstick