ISBN: 0-03-028931-9

Chapter 3 Analysis of Financial Statements

On May 19, 1999, Dell Computer Corp. announced that its first quarter earnings were 42 percent higher than those reported one year earlier. This dramatic increase in earnings was roughly in line with Wall Street projections. Nevertheless, Dell's stock price fell nearly $4 a share immediately after the announcement.

At first glance, the market's response appears puzzling. However, analysts zeroed in on the fact that Dell's profit margin in the first quarter had fallen considerably. In recent months, the computer business had become a lot more competitive, and this increased competition had pushed down computer prices. Dell's earnings report indicated that lower prices for consumers resulted in lower margins for Dell's shareholders.

Dell stockholders have done fantastically over the past ten years. A $10,000 investment in Dell in early 1989 would be worth over $5 million today. So, while Dell's increased earnings might suggest that the stock will continue to do well, the lower reported margins raised concerns that the company's earnings growth in the years ahead might be lower than previously expected.

Wall Street's response to Dell's announced earnings brings home several important points. First, investors and others outside the company use reported earnings and other financial statement data to determine a company's value. Second, analysts are primarily concerned about future performance – past performance is useful only to the extent that it provides information about the company's future. Finally, analysts go beyond reported profits and dig into the details of the financial statements.

So, while many people regard financial statements as "just accounting," they really are much more. As you will see in this chapter, the statements provide a wealth of information that is used for a wide variety of purposes by managers, investors, lenders, customers, suppliers and regulators. An analysis of its statements can highlight a company's strengths and shortcomings, and this information can be used by management to improve performance and by others to predict future results. As you will see both here and in Chapter 4, financial analysis can be used to predict how such strategic decisions as the sale of a division, a major marketing program, or expanding a plant are likely to affect future financial performance.

DISCUSSION QUESTIONS

1. In your opinion, which should be the most important consideration in stock valuation, current performance or future expectations?
2. Do you think Dell Computer will be able to sustain high growth despite increased competition in its industry? Why or why not?

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