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 low risk

High ROE and high 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:

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 one key product is considered to be risky than companies with a wide range of products.

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.

The Purchasing Policy Guidelines of the Northern Services Inc. indicate that the company is committed to procuring its goods, products, and services from a diversified pool of vendors, contractors, and service providers.

Despite these guidelines, Northerns purchasing manager prefers to maintain a small cadre of suppliers that he knows and trusts.

How would you expect this situation to affect the assessment of Northerns financial condition and performance?

The purchasing managers behavior should be expected to decrease Northerns riskiness. His belief that the use of trusted suppliers will prevent or eliminate any inventory or supply delays or outages is, no doubt, correct.

The purchasing managers behavior should be expected to increase Northerns riskiness by increasing its exposure to potential supply shortages or mistimed deliveries.

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.