Financial Accounting: In an Economic Context

ROE EXERCISE: MANAGING CURRENT LIABILITIES

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). The management of the nature and level of current liabilities represents important operating activities.

As illustrated by the ROE model, management can increase return on equity by practicing leverage—using borrowed funds to finance investments that provide returns that exceed the cost (e.g., interest) of borrowing. However, at the same time, this strategy imposes a responsibility on management to ensure that the company can remain solvent— generate enough cash to meet the obligations associated with the borrowings as they come due. Consequently, current liabilities play a particularly important role in the solvency ratios (see Chapter 5, Figure 5-3)—current ratio, quick ratio, interest coverage, and accounts payable turnover. Assessing how these ratios change relative to changes in a company's leverage position is an important part of financial statement analysis.