Financial Accounting: In an Economic Context

ROE EXERCISE: MANAGING INVESTMENTS IN EQUITY SECURITIES AND RETURN ON EQUITY

The ROE model, introduced and illustrated in Appendix 5A, provides a framework linking the management of a company's operating, investing, and financing activities to its return on the shareholders' investment (return on equity). In terms of this model, investments in equity securities can be viewed as either short-term or long-term.

Short-term investments in equity securities are part of working capital management, which is most directly concerned with maintaining liquid assets to meet debts as they come due. Management invests in short-term equity securities to achieve both liquidity and some level of return. The current and quick ratios reflect that level of investment, and the role of these two ratios in the ROE model is discussed in the ROE Exercise at the end of Chapter 6.

Long-term investments in equity securities are designed to generate returns for the shareholders. The success of such investments is measured by comparing the size of the return to the size of the investment. Accordingly, return on assets (ROA) is an important performance barometer for long-term investments in equity securities. As indicated in the ROE model, asset turnover is a key determinant of ROA, and ROA is a key determinant of ROE.