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Author: caledonia Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 3916  
Subject: Re: ROE penalizes cash? Date: 11/25/1997 12:45 PM
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I certainly agree that one balance sheet ratio does not represent sufficient data to make an investing decision, but I must quibble with a few points regarding ROE made by Deep Blue.

First, all liabilities should be included in the debt/equity ratio. After all, all debt must be repaid unless the company goes bankrupt. Therefore, the debt/equity ratio for QUIP is actually .52 (8.5M in liabilities/16.4M in equity). Were QUIP to give all its 11.1M in cash away, the deb/equity ratio would increase to 1.60 (8.5M in liabilities/5.3M in equity). While neither of these ratios is indicative of a heavily leveraged company, the increase in leverage most likely would result in a slightly higher cost of capital for the company (since lenders charge higher prices for riskier loans).

More importantly, Deep Blue ignores the issue of liquidity in analyzing the effects of QUIP giving away all of its cash. Most likely, QUIP would go out of business were it to give all its cash away. It's ROE in such a scenario would then be 0%, hardly an improvement over 15%.

Let's assume, for educational purposes, that QUIP would still be able to earn $2.6M/year even if it gave away all its cash. Why, then, is it currently holding the $11.1M in cash it reports on its balance sheet? Clearly, the company is not making effective use of its cash if earnings were to remain the same in the absence of the cash. I would rather that QUIP pay that cash out to shareholders via share buybacks and/or dividends rather than sit on it and generate no incremental value from it.

Which brings me to my main point about ROE. Ratios like ROE and ROA are intended to give analysts an understanding of how efficiently companies are deploying their assets. These ratios are particularly helpful when used to compare different companies in the same industry. True, they are not sufficient by themselves to guide one's investment decisions. But the same can be said for any single piece of information derived from financial statements.
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