Importance of Financial Ratios

I thoroughly enjoyed your article on ratio analysis covered in your previous issue. I liked the way you mentioned in detail as to how a person should not just look at one ratio in isolation but instead, consider multiple ratios in conjunction. Can you please explain how one can look at the return on equity and other ratios such as the return on assets to arrive at a decision?

- Sareet Kunden

Editor Responds: Thank you for writing to us! We are glad to know that you liked our article. Both RoE and RoA are different but they are important metrics in considering management’s performance. A strong RoA combined with a strong RoE indicates that the management is using their assets efficiently and is doing a good job in generating returns for their shareholders. However, if RoA is low or the debt on the books is high, a high RoE can give a false impression to the shareholders. This is simply because RoA, unlike RoE, considers total assets in the denominator, which is essentially equal to shareholders equity + total liabilities. Hope this gives you some clarity regarding the concept. Keep writing to us. It’s a pleasure to receive your feedback!