Business - Return on Equity - Essay Example

The duty of corporate management is to effectively manage these three components so investors are convinced beyond reasonable doubt that they can indeed get good Return on Equity should they invest in the organization. In the same vein, investors can also foresee the ability of the management to do a proper job as regards their investment purposes. The calculation of return on Equity is based on one year’s worth of earnings which is then divided by the shareholder equity for that particular year.

These earnings are usually obtained from the financial statements of the company or from the Statement of Earnings which are computed on the end year basis (Graham and Dodd 90). It must be remembered that ROE is one of the most critical factors that determine the viability of an organization with regard to investment purposes. Investors are normally very keen in the figure as it clearly indicates the progress of the company as a function of capital investment. In its basic assessment, Return on Equity simply reveals how much a company earned and how this profit relates to the shareholders equity in the company.

A higher ROE is therefore suitable for a company on the basis of investment as it will attract more investors. In the same vein, a low ROE is an indication that the shareholders equity is not sufficiently compensated as a consequence of the low profits earned. Any investor in the present age is certainly inundated with myriad information which they are expected to analyze and make proper decisions on whether to invest or not. That creates much of the trouble considering that investment is a very critical decision to make and not all investors are well versed in accounting issues.

It therefore creates the need to present information in a manner that even the laymen in accounting can effectively comprehend. Such is the importance of ROE which eliminates the trouble of wading through loads of information in the analysis of a company (Swanson and Marshall 56-8). In most cases, people merely look at the plain earnings of a company which do not in any way reveal any sign of success. Return on equity on the other hand, clearly encompasses the previous earnings retained from the other years which serve to inform the investors of how effective the reinvestment process is.

The management’s fiscal adeptness is clearly seen in the ROE analysis as compared to other measures like annual earnings per share. In an increasingly competitive and risky financial environment, each and every investor seeks to realize the highest return without taking chances with risks. It is critical to realize that the investment decisions are made on the basis of a company’s returns. Thus, a company with a ROE of 10% in the present year may not necessarily attain the same level of profitability in the next year.

However, if the history of the company reveals such a trend, an investor may as well conclude that the future years will reflect the past and can then make the decision to invest or not. A major challenge that underlies the usage of ROE is its sensitivity to leverage. It increases with greater amounts of leverage if proceeds from debt refinancing are reinvested into the business at a rate greater than the borrowing rate. The ROE can also overstate the economic value of the business is the situations of depreciation and in projects with longer lifespan.

The investment decision of any firm is normally a function of many factors the most