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, which of the following projects will a manager likely choose if his or her bonus is solely based on the ROE of the next project?

Project Y, with 40% ROE and a small investment, generating low expected cash flows

Project X, with 35% ROE and a large investment, generating high expected cash flows

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:

Analyze the firms financial ratios over time

Compare the firms financial ratios with other firms in the industry for a particular year

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.

Western Amalgamated Corp.

Western 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 Westerns financial condition and performance?

Its low barriers to entry expose Western to increased risk of competition, which could negatively affect 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 Western to decreased risk of competition, which could improve the predictability of its expected future sales revenues.