Question

Why the perfoamnce of comapnies cannot only be relied on financial measures such as ROC ROE EVA ratios etc . Explain the reason why and provide the limitations of those ratios.

Answer 1

the companies cannot rely on ratios like ROE,ROCE AND EVA ratios anymore because these ratios are not stated relation to a benchmark measure. Shareholders require a minimum rate of return , which these performance measures ignore.

the weaknesses of these ratios ROE/ROCE are :

1) they consider net income, they do not consider the cash flows which is a more important indicator of financial performance.

2) ROE/ROCE can be calculated by using past financial information and this information can be manipulated easily.

3) it uses percentage to analyze information. by using percentage, it might in ignore the real data. by comparing data in percentage forms, the real data may get lost and the manager may end of choosing a smaller project on the basis of a higher ROE/ROCE

4) managers can manipulate data, to increase the net income and artificially inflate the ratio.

EVA: after tax operating income - ( investment in assets * cost of capital )

disadvantages of this ratio :

1) finding the correct cost of equity is difficult in calculating EVA. the cost of equity of a small company is different from the cost of equity of a large company. EVA does not consider the difference in size. it considers a single cost of equity for its computation irrespective of size differences.

2) EVA can be used for personal gains for the manager , which might not be profitable for the company as a whole.

3) there maybe initiatives on part of the manger to focus more on short term gains rather than long term gains and artificially inflate the short term performance.