Question

Return on Equity (ROE) Discussion: Return on Equity (ROE) Discussion Due: Day 4, 11:59 p.m. E.T. Grad This activity is worth 10 points and counts toward Participation, ing: which makes up 15% of your final grade. Return on Equity (ROE) is used, and some say "abused" when measuring the financial performance of a firm. What are your thoughts on ROE specifically, as well as other financial ratios generally, when forming an opinion on the financial performance of a firm?

Answer 1

Return on Equity (ROE) measures the income generating capacity of the firm, vis-à-vis equity capital employed. Computed in percentage terms, by dividing equity earnings during the given period (normally one year) by the amount of average equity funds. Equity earnings represents profit after tax less dividend on preference shares, if any. Since the equity funds comprise of net worth of the firm, this ratio is also called Return on Net Worth. Maximizing shareholder wealth is the fundamental objective of business entity and hence this ratio is considered very important.

Limitations of ROE and other financial ratios:

Financial ratios are mainly based on historical data. Even the ratios of future periods are calculated based on past trends. Hence the inference about the present and future need not be reliable. A case in point is the inflation. All accounting numbers and the ratios calculated based on them are influenced by inflation. Change in inflation rate can distort the assessments.

Ratio analysis is largely used for comparing among different firms. Size and scale and also the operating environment might be different making such comparisons not yielding desired results.

Another limitation is the difference in accounting methods used- between companies as well as for a company, between different periods. A typical example is the method of depreciation employed which can cause major changes in profitability and the inference of related ratios.

Accuracy of financial statements is crucial in the acceptability of ratio analysis based on them. Though not in large scale, inaccurate reporting is noticed, intentional or not, in financial reporting affecting the reliability of ratio analysis.