The Disadvantages of Using Return on Equity

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ROE can lead to skewed conclusions about the financial health of a company.
ROE can lead to skewed conclusions about the financial health of a company. (Image: Stockbyte/Stockbyte/Getty Images)

Return on Equity (ROE) is a measure of the efficiency of a company's capital. It is one of many ratios used in the management accounting function to ensure that the company is on track financially. The ROE does not tell the whole story, however, and it can provide a skewed and incorrect view of business operations if it is not considered with other indicators.

What is ROE?

Return on equity is a ratio calculated by dividing net income by the book value of shareholder equity. Like most ratios, it is most useful when viewed over time to see if ROE is increasing or decreasing. The purpose of ROE is to indicate how efficiently a company uses the capital it receives from its owners to generate an investment return to those shareholders. Because net income can be manipulated in many different ways, however, ROE is not a reliable indicator of efficiency when used on its own.

The Effect of Leverage

A company has two options when it wants to raise funds to improve profits. It can take on debt or it can take on new equity owners. It is critical for a company to be able to employ this investment efficiently, regardless of source. The ROE only reflects the results of a company's equity investments, though. This means that a company could be highly-leveraged with a risky amount of debt and it will show an improving ROE if that debt is generating income. ROE must be looked at with other measures such as Return on Investment in order to present a more balanced snapshot of the company.

Negative ROE on Start Up

Another situation for which the ROE produces anomalous results is the start-up phase. Companies with huge future potential may have no or negative net income in the first few years even though they have significant shareholder investment. The ROE for these companies is zero or even a negative. This does not tell the whole story of the company and minimizes its potential down the road. An analyst must look at how long the share capital has been in place to get a solid look at start-ups. Newer capital will take longer to produce increases in the bottom line, which raises ROE.

Subjectivity

The ROE calculation is based on net income rather than revenues. Net income is defined as revenues minus expenses. Revenues are straightforward and easily understood by most investors. However, expenses are subject to many manipulations through the company's accounting policies, both intentionally and unintentionally. For example, a company with significant amounts of capital assets will have a large depreciation expense, which lowers the ROE as compared with a company with fewer assets. When and how a company chooses to write down assets will also impact ROE, even though it has no impact on the company's overall financial well-being.

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