Financial Accounting: In an Economic Context

ROE EXERCISE: MANAGING LONG-TERM DEBT

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 long-term debt represents an important financing activity.

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. Issuing bonds and long-term notes and using capital leases can generate huge amounts of funds that can be invested in projects, creating shareholder returns without requiring any shareholder capital. The result is upward pressure on ROE. This strategy, however, does increase a company's risk because it creates obligations to make future cash payments regardless of whether the projects are successful.

Key ratios within the ROE model that address these issues include common equity leverage, capital structure leverage, long-term debt as a percent of total assets, interest coverage, and interest expense as a percent of sales (see Figure 5-3). Analyzing these ratios and how they relate to changes in ROE is useful in assessing how companies manage their financing activities and, accordingly, is an important part of financial statement analysis.