CHAPTER
3
Fundamental Interpretations
Made From Financial Statement
Data
CHAPTER OUTLINE:
I. Financial Ratios and Trend Analysis
A. Company Data Over Time
B. Company Data Compared to Industry Data Over Time
II. Return on Investment
A. Significance
B. Method of Calculating
III. The DuPont Model—An Expansion of the ROI Calculation
A. Margin and Turnover
B. Significance of Model
C. Rules of Thumb for ROI, Margin, and Turnover
IV. Return on Equity and Rules of Thumb
V. Working Capital and Measures of Liquidity
A. Working Capital
B. Current Ratio
VI. Illustration of Trend Analysis
A. Profitability and Liquidity Data
B. Return on Investment and Return on Equity
C. Margin and Turnover
D. Working Capital and Current Ratio
Chapter 3 Fundamental Interpretations Made from Financial Statement Data
PEDAGOGICAL NOTES:
Chapter 3 introduces students to some fundamental financial statement analysis concepts that
provide a framework for their understanding of financial accounting as they proceed through
Chapters 4-10. Chapter 11 presents a comprehensive explanation of how to use financial
statement data, including a full complement of financial ratios as well as common size analysis.
Many instructors prefer to defer coverage of the ROI, ROE, and liquidity measures until students
have a better understanding of financial accounting concepts, and therefore assign Chapters 3
and 11 concurrently.
TEACHING/LEARNING OBJECTIVES:
Principal:
1. To explain the return on investment (ROI) calculation, its significance as a measure of
3. To explain the calculation and significance of working capital, the current ratio, and the
acid-test ratio.
4. To provide some broad “rules of thumb” so students can form a perspective about the ratio
Supporting:
5. To introduce some of the interpretations of financial statement data made by users to support
7. To illustrate trend analysis using the measurements introduced in this chapter.
TEACHING OBSERVATIONS:
1. In our opinion, the return on investment concept is one of the most important ideas that
students should understand about business operations. The ROI concept (using the DuPont
2. The DuPont model can be used to contrast the profitability components of two or more
industries that achieve comparable total profitability. For example:
Margin * Turnover = ROI
Grocery stores 1% * 15 = 15%
Heavy equipment manufacturers 15% * 1 = 15%
Retail jewelry outlets ? ? ?
Get students involved in the discussion by asking them to make educated guesses about the
industry averages for margin and turnover in the jewelry and computer industries. Balance
sheet components affecting turnover can easily be identified by most students—but be sure to
emphasize that the denominator used in the turnover (and ROI) calculation is average total
assets—and not just inventory! Ask them, “Which of the firm’s assets really turn–over, as
such?” Point out that manufacturers make substantial investments in long-term assets (such
3. The impact on an industry that achieves above average profitability can be used to illustrate
the cyclical pattern of industry profitability over time. When industry profits are unusually
high, more firms enter the industry. This leads to increased competition, which leads to
4. It should be emphasized that financial statements are the sources of data used in these ratios.
As such, students should be alerted to the impact on the data and ratios of generally accepted
accounting principles that have already been introduced (e.g., original cost principle, unit of
ASSIGNMENT OVERVIEW:
NO.
LEVEL
AND TIME
OTHER
COMMENTS
M3.1.
Easy, 5-7 min.
Quick in-class exercise to reinforce DuPont model.
M3.2.
Easy, 5-7 min.
See M3.1.
M3.3.
Med., 5-8 min.
Students must calculate the average stockholders’ equity before ROE.
M3.4.
Med., 5-8 min.
Give students hint: “Divide sales by turnover for average total assets.”
M3.5
Easy, 3-5 min.
Straightforward working capital and current ratio exercise.
M3.6.
Easy, 3-5 min.
Identification of current asset and current liability accounts.
E3.7.
Easy, 3-5 min.
Practical way to introduce the risk / return tradeoff.
E3.8.
2
Easy, 3-5 min.
See E3.7.
E3.9.
Med., 5-8 min.
Emphasizes that ROI should exceed the cost of debt.
E3.10.
2
Med., 7-10 min.
Excel exercise. See E3.9. Good homework assignment for basic
spreadsheet skills.
E3.11.
Med., 7-10 min.
Good in-class demonstration of ROI using the DuPont model.
E3.12.
Med., 7-10 min.
See E3.11. Good homework assignment.
E3.14.
Med., 5-10 min.
See E3.13. Good homework assignment.
E3.15.
E3.16.
Med., 7-10 min.
See E3.15.
P3.17.
Easy, 10-12 min.
Students respond well if supported with current data from Value Line
Straight-forward problem using Campbell’s financial statement data.
P3.19.
Easy, 5-8 min.
Shows that liquidity measures may send conflicting messages, and
that cash and net income are not directly related.
P3.21.
Med., 8-12 min.
The key to part b is to see that the “investment” amount is reduced.
Give this as a hint.
P3.22.
Med.-Hard, 20-30
Excel problem. Practical way to emphasize the importance of
C3.23.
Med.-Hard, 20-40
Explain to students that C3.23. is the first of a series of short case
C3.24.
Med.-Hard, 20-40
min.
Excellent capstone case. Optional continuation provides an
opportunity for a good discussion of trend analysis without getting
Instructor’s Manual / Solutions Manual
SOLUTIONS:
M3.1.
The following model can be used to help answer any questions related to ROI:
ROI = MARGIN x TURNOVER
M3.2.
The following model can be used to help answer any questions related to ROI:
ROI = MARGIN x TURNOVER
M3.3.
Solution approach:
Net assets = Assets – Liabilities = Stockholders’ Equity
Thus, “net assets” at the end of the year = ending SE
M3.4.
The following model can be used to help answer any questions related to ROI:
ROI = MARGIN x TURNOVER
M3.5.
M3.6.
$34,200 cash + $46,400 accounts receivable + $29,600 inventory = $110,200 current assets
E3.7.
a.
Velterine’s investment is preferred because it has the higher ROI.
Risk is a principal factor to be considered.
Amount of return $740 $850
E3.8.
a.
Interest earned on the savings account: $5,000 * 3.5% * 6/12 = $87.50
b.
Interest earned on loan to Simone: ($5,200 amount repaid – $5,000 loan) = $200.00
Rate of return for 6 months is $200 / $5,000 = 4%
Rate of return on an annual basis = 4% * 2 = 8%
E3.9.
ROI * amount invested = amount of return
Solution approach: Calculate the amount of return from each alternative, then calculate the
ROI of the additional return from the higher paying investment relative to the $4,000 that
Chapter 3 Fundamental Interpretations Made from Financial Statement Data
E3.10.
a.
$15,000 * 4% = $600 return
b.
Return on $20,000 at 7% = $1,400
d.
Solution Approach: A “prudent investor” would be wise to take the following factors into
consideration before choosing between alternative investment opportunities:
1. How long is the investing horizon of each investment? In this case, both investments
2. How flexible is the investment? In this case, the savings account would be more flexible
3. What is the relative risk of each investment? In this case, both investments would be
4. How does each alternative investment fit within the investor’s investing objectives?
E3.11.
The following model can be used to help answer any questions related to ROI:
a.
16.8% ROI = (8% Margin * Turnover)
1.1 Turnover = (Sales / $1,600,000 Average total assets)
c.
23.2% ROI = (Margin * 2.9 Turnover)
E3.12.
a.
Margin = ($61,750 Net income / $1,625,000 Sales) = 3.8%
b.
Margin * Turnover = ROI
($241,500 Net income / $3,450,000 Sales) * Turnover = 16.1% ROI
2.3 Turnover = ($3,450,000 Sales / Average total assets)
E3.12.
(continued)
1.2 Turnover = (Sales / $1,700,000 Average total assets)
Sales = $2,040,000
E3.13.
Remember that “net assets” is the same as “stockholders’ equity.”
E3.14.
a.
14.7% ROI / 3.5 Turnover = 4.2% margin
E3.15.
a.
Do Not Prepay Prepay
Accounts Payable Accounts Payable
Current assets ………. ……….. ……….. ……….. $ 180,000 $160,000
Payment of the accounts payable does not affect working capital, but does improve the
current ratio. Is this balance sheet “window dressing” worth the opportunity cost of not