Question

In: Finance

What are some problems with ROE?

What are some problems with ROE?

Solutions

Expert Solution

Answer :

Management of the company should strive to improve the wealth of the share holders of the company.

If a company takes steps to improve the ROE, it does not mean that the shareholders wealth also increased?

There some problems which may arise when the firm uses ROE as the sole measure of performance.

Problems:

1.ROE does not consider the risk. While shareholders clearly care about returns, they also care about the risk.

2.ROE does not consider the amount of the invested capital.

3. true measure of profitability should be focused on the operating side of the equation, without allowing the financing decisions to have a big impact.

By only using the shareholder’s equity as the denomination, ROE becomes extremely susceptible to financing decisions, as accompany significantly boost ROE by taking one more leverage and increasing its risk

4.ROE is another one of the advanced metrics that companies often use to set performance targets that executives need to hit to earn their annual and long term bonuses. Consequently, executives will be more likely to manipulate accounting earnings, structure transactions to keep them of the balznce sheet and take on more leverage in order to boost ROE.


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