Question

Last year's return on equity was 30%. This year the ROE has decreased to 20% even though the firm's earnings equaled last year's earnings. The firm has no preferred stock. What caused the decrease?

Answer 1

Answer:

The response options are:

a) Equity decreased by 10%.

b) Equity decreased by 50%.

c) Equity increased by 10%.

d) Equity increased by 50%.

The correct answer is: d) Equity increased by 50%.

Explanation:

The main reason that leads financiers to use this ratio is to know how the capital of a company is being used. The higher the ROE, the greater the profitability that a company can have depending on the own resources it uses for its financing.

Profitability can be seen as a measure of how a company invests funds to generate revenue. It is usually expressed as a percentage, and has as a formula:

Return On Equity = Net Profit after own Taxes / Capitals.

Understanding by Own Capital the difference between the asset and the liability, or what is the same, the equity according to the current General Accounting Plan, although from this net worth the benefits should be deducted since these are also integrated within said balance sheet item and obviously they have not been contributed by the shareholders.

ROE is like a speed limit; Unless the company does not acquire additional liquidity, it cannot grow its earnings per share at a rate higher than ROE (this must be taken into account when using Graham's method to value a company).

A negative aspect of ROE is that, depending on net earnings, and these being manipulable by management, ROE is not necessarily a reliable indicator.