Can Return on Equity Be Too High?

Q If a company has a return on equity above 100 percent, is that good or bad? — E.M., Rochester, Minnesota

A It requires a closer look. Return on equity (ROE) reflects the productivity of the net assets (assets minus liabilities) that a company has at its disposal. It’s determined by dividing net income by shareholder equity. (Net income is found on a company’s income statement, while shareholder equity is found on the balance sheet and is what you get when you subtract liabilities from assets.) In general, the higher the ROE, the better.

Note, though, that some ROEs are artificially high because the company has taken on a lot of debt or has bought back a lot of shares. These actions shrink shareholder equity, driving up ROE.

Q What’s “the accrual method”? — S.L., Maryville, Tennessee

A It’s one of many accounting concepts worth learning to help you understand companies’ financial statements.

In the accounting world, “revenue” (sales) doesn’t necessarily represent the receipt of cash in a sale. Many companies are required to book sales when goods are shipped or when services are rendered. But others can record sales when cash is received, or incrementally, as longterm contracts proceed through stages of completion. With the accrual accounting system, the revenue on a company’s income statement may not have actually been received by the company.

Imagine, for example, PieMart Inc. (ticker: GOBBL). With the accrual method, if it has shipped off a thousand pies but hasn’t yet been paid for them, those sales still appear on the income statement. The checks in the mail are reported as “accounts receivable” on the balance sheet. (When receivables are growing faster than revenue, that can be a sign of trouble.)