Financial Accounting: In an Economic Context

ROE EXERCISE: MANAGEMENT OF WORKING CAPITAL AND RECEIVABLES AND RETURN ON EQUITY

Management's goal is to maximize shareholder wealth by choosing investments (e.g., people, inventories, plant and equipment, other companies) that generate an overall return exceeding the cost of the debt and equity capital used to finance the investments. Stated another way, management must manage its operating, investing, and financing decisions in a manner that maximizes the return on the shareholders' investment in the company. 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 a company's working capital and receivables plays an important role in the ROE model via three financial statement ratios: current ratio (current assets/current liabilities), quick ratio ([cash + short-term investments + accounts receivable]/current liabilities), and receivables turnover (sales/average accounts receivable).

Current and Quick Ratios

The current and quick ratios provide measures of solvency—the ability to meet debt obligations as they come due. Companies that finance their operating and investing activities through borrowing (leverage) often maintain liquid-asset (e.g., cash, marketable securities, accounts receivable, inventories) balances because it lowers the risk borne by the lender by helping to ensure that ...