Question
7. More on ratio analysis Analysts and investors often use return on equity (ROE) to compare profitability of a company with other firms in the
7. More on ratio analysis
Analysts and investors often use return on equity (ROE) to compare profitability of a company with other firms in the industry. ROE is considered a very important measure, and managers strive to make the companys ROE numbers look good.
If a firm takes steps that increase its expected future ROE, its stock price will increase.
Based on your understanding of the uses and limitations of ROE, a rational investor is likely to prefer an investment option that has:
High ROE and high risk
High ROE and low risk
Suppose you are trying to decide whether to invest in a company that generates a high expected ROE, and you want to conduct further analysis on the companys performance. If you wanted to conduct a trend analysis, you would:
Compare the firms financial ratios with other firms in the industry for a particular year
Analyze the firms financial ratios over time
You decide also to conduct a qualitative analysis based on the factors summarized by the American Association of Individual Investors (AAII). According to your understanding, a company with less competition is considered to be risky than companies with multiple competitors.
The American Association of Individual Investors (AAII) has identified several qualitative factors that should also be considered when evaluating a companys likely future financial performance. Consider the scenario and indicate how you would expect the described event or situation to affect the described business organization.
Northern Services Inc.
Northern assembles computers in the owners garage from parts the owner orders over the Internet. This industry is characterized by low barriers to entry, including few operating licenses or governmental approvals, and small investments in productive equipment or facilities.
How would you expect this situation to affect the assessment of Northerns financial condition and performance?
Its low barriers to entry expose Northern to decreased risk of competition, which could improve the predictability of its expected future sales revenues.
Although nonquantitative factors may be relevant to a companys financial evaluation in general terms, the details of this specific situation are not relevant to the firms financial condition or performance.
Its low barriers to entry expose Northern to increased risk of competition, which could negatively affect the predictability of its expected future sales revenues.
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