chapter 3 text - 48 PA RT 2 Financial Statements and...

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Financial Statements and Long-Term Financial Planning WORKING WITH FINANCIAL 3 STATEMENTS 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 Journal 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 same time, investors were willing to pay only $24, $20, and $15 for each dollar earned by Cisco, Tootsie Roll, and Harley Davidson, 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 $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
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This note was uploaded on 03/11/2012 for the course ECON 107 taught by Professor Callahan during the Spring '12 term at London College of Accountancy.

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chapter 3 text - 48 PA RT 2 Financial Statements and...

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