Question

Required:

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? Write at least 250 words.

Please don't copy from anywhere. Write in your own words.

Answer 1

Return on equity is a profitability ratio that calculates how many dollars of profit a company generates with each dollar of shareholder’s equity.

The formula for return on equity (ROE) is given below:

Return on Equity= Net Income/Shareholder’s Equity

It is a measure of efficiency. When ROE is increasing, it means that a company is increasing its ability to generate profit without the need for additional capital. It is also an indicator of how well a company’s management is using shareholder’s capital.

It cannot be used to make comparisons with firms outside the industry.

If the value of shareholder’s equity reduces, return on equity increases. Writedowns and share buybacks can be used to boost ROE. A high level of debt can also be used to artificially boost ROE. Return on equity can be abused this way.

The purpose of using ratios is to evaluate management performance in profitability, efficiency and risk. It is a form of financial statement analysis. It is used to project future performance. Liquidity ratio like current ratio, cash ratio and quick ratio measures how liquid a company’s assets are compared to its liabilities. Turnover ratio helps to understand how long it will take to convert receivables and inventory to cash and pay its suppliers.

Operating performance ratios like net profit margin and return on total assets can be used to interpret how well the company is performing and generating revenue in comparison to the assets used. Financial risk of a company can be analyzed using ratios like interest coverage ratio and leverage ratio.

The ratios of a company can be used to compare that of other companies in an industry to a get better understanding of the financial health. It can be compared with those of previous years to see how the company is progressing.

I hope that was helpful :)