In this article, we will explain the major limitation of return on equity that you should know if you are going to calculate, read, analyze and use return on equity to make a decision.
Before we start off with the limitation of return on equity, we have to understand the concept of return on equity, and the formula is an important part to know.
Well, return on equity is one of the financial ratios that is used to assess how well the entity generates net income over the equity fund that is invested by shareholders.
The two most essential items that use to calculate this ratio are net income during the period compared shareholders’ equity at the end of the period.
It is very important to understand what these two items are, and if you don’t know. Google them and then continue this article.
Okay, now we assume you understand what are net income and shareholders’ equity. Now, let’s start with the limitation of ROE.
#1 Ignore cash flow
As you might know, ROE is mainly used as a financial indicator to assess the performance of the entity. Maybe your entity also uses it to assess financial performance.
You can check with your CFO later, not now. In general, the board of directors set the percentage of ROE for executive directors and asks for the committee to lead the entity to generate net income to hit this rate.
By focusing on ROE, management might not focus on cash flow which is the most important one. ROE uses only net income which might be not collected from the customers. Make sense right.
Now we move to the other factors, which are Past Financial Data
#2 Use Past Financial Data
As we all know ROE is calculated by using all financial information and yes that financial information could be manipulated more easily than the non-financial figure. To explain this in more detail, let go of the types of fraud.
As you might know, there are two types of fraud, one is fraud by stealing company assets ( We use these simple words for better understanding) and the other is fraud through Financial Statements.
Fraud through Financial Statements, management tries to manipulate financial information to get a better result; for example, net income, than it should be.
Same as ROE, to get a better ratio or hit the ratio set by the board of directors or required by investors, management may try to manipulate financial information. Comment below, if you want to know how financial information or financial statements could be manipulated.
#3 It based on %
You see, the result of the calculation of ROE is % right. And the disadvantage of ROE on this % is that it uses only % to compare, and it fails to measure the real amount that an entity could generate. For example, the same project might earn a high % ROE than the big project.
Yet, in terms of money, the small project might earn only 200,000 USD while the big project earns 2,000,000 USD. Using ROE might lead management to decide to choose the small project.
#4 Play Around with Equity
Let’s come back to the formula of ROE and let see how management could play around with equity to get a better ROE ratio. For example, to increase ROE, there are two possibilities to do. One is to maintain the same Net income and find a way to decrease equity.
And the second method is to maintain equity and find to way to increase net income. What we mean to increase net income here is not about increasing the operational performance but increasing the net income by using the accounting technique.
For example, failing to accrual some expenses at the year-end of over recognize income at the year. You might know some of the management try to manipulate income by issuing income to fake customers and then return back at the beginning of the next year.
But, this is enough for income now let’s see the equity. Actually, to reduce some of the equity is trying to purchase shares back by using a bank loan.
The entity might approach the stock market agency and then try to buy a large amount of stock equity.
In this technique, the entity wants to convert some of the equity to liabilities. This will help them to get better ROE.
Noted: As a professional accountant, you should not try to use this trace to gain the benefit.
Written by Sinra