Financial Accounting: In an Economic Context

ROE EXERCISE: MANAGING LONG-LIVED ASSETS 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). For many companies (e.g., manufacturers, services, and companies that grow via acquisition) the management of long-lived assets is an important investment activity.

Long-lived asset turnover (sales ÷ average long-lived assets) is a measure of the extent to which the investment in long-lived assets generates sales volume. An increase in this ratio (i.e., increasing the level of sales per dollar invested in longlived assets) puts upward pressure on total asset turnover, which puts upward pressure on return on assets (ROA), which in turn puts upward pressure on return on equity (ROE). Put simply, generating a large amount of sales with a small investment in long-lived assets is better for the shareholders than generating a small amount of sales with a large investment in long-lived assets. Consequently, an important role of management is to ensure that all long-lived assets (property, plant, and equipment and intangibles) are efficiently helping to generate the sales of goods and/or services. As indicated in the ROE model, effective management in this area can lead to higher shareholder returns.