A key problem with return on equity as a measure of comparative performance is:

A key problem with return on equity as a measure of comparative performance is:
A . that return on equity is not adjusted for risk
B . that return on equity are not adjusted for cash flows being different from accounting earnings
C . that return on equity measures do not account for interest and taxes
D . that return on equity ignores the effect of leverage on returns to shareholders

View Answer

Answer: A

Explanation:

The major problem with using return onequity as a measure of performance is that return on equity is not adjusted for risk. Therefore, a riskier investment will always come out ahead when compared to a less risky investment when using return on equity as a performance metric.

Return on equitydoes not ignore the effect of leverage (though return on assets does) because it considers the income attributable to equity, including income from leveraged investments.

Return on equity is generally measured after interest and taxes at the company wide level, though at business unit level it may use earnings before interest and taxes. However this does not create a problem so long as all performance being covered is calculated in the same way.

Cash flows being different from accounting earnings can createliquidity issues, but this does not affect the effectiveness of ROE as a measure of performance.