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Is ROE the Best Ratio to Evaluate the Return of Investment Fund?

8:00 AM  Pisstol Aer   Labels:
A number of investment gurus have been talking about using Return on Equity (ROE) to measure the return on investors’ fund. It is a key measurement on a company’s profitability. However, it has practical limitation.

ROE is dividing net income by shareholders’ equity (SE) while SE is the difference between assets and liabilities. I.e. SE = Assets – Liabilities.

Say a company is having $3,000 in assets and $1,100 in liabilities. By calculation, SE will be $1,900. With net income of $250, the company is generating 13% on ROE ($250/$1,900).

Now, let us assume a company is also having $3,000 in assets but with $2,300 in liabilities. By calculation, the $250 net income will produce 36% ROE. So, can we conclude that this company is doing better as it has higher ROE with higher debts? What happen if a company pays off its debts? Its ROE will go down. Isn’t it something wrong somewhere?

To counter this problem, Return on Asset (ROA) may be more suitable to evaluate return. As a matter of fact, assets consist all the capital employed (both SE and liabilities) to generate return and it will be more meaningful.

As a rule of thumb, a company that generates 7% ROA is good but 10% is desirable and higher is better.
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Is ROE the Best Ratio to Evaluate the Return of Investment Fund?
Is ROE the Best Ratio to Evaluate the Return of Investment Fund?
Reviewed by Pisstol Aer
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