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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.

An increase in ROE would imply an increase in shareholder wealth.

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 comparative analysis for the current year, you would:

Compare the firms financial ratios for the current year with its ratios in previous years

Compare the firms financial ratios with other firms in the industry for the current 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.

Eastern Manufacturing Products Inc.

The Purchasing Policy Guidelines of the Eastern Manufacturing Products 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, Easterns 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 Easterns financial condition and performance?

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.

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

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