The old man shared this story with Sean:
“There was a boss who wanted to employ a manager for his company. He had 3 candidates and thus wanted to test to see who was the best candidate. The first candidate walked into the interview room and sat down. He was a mathematician. The boss of the company said, “I will ask you a question and I require you to answer it as fast as you can.” The mathematician nodded to indicate that he was ready. The question burst out at the rate of a machine gun firing bullet, “WHAT IS 2 PLUS 2?”. The mathematician, immediately replied, “It is 4.00000000..., how many decimal points do you want?” The boss was pleased. He wanted someone who could react to sudden outbursts and remain calm. He commented the mathematician and told him he will be informed of the interview results.
The next candidate was an engineer. After the boss explained his demand, he was administered the same question, “'WHAT IS 2 PLUS 2?!”, yelled the boss. “It is between 3.9875 and 4.01526.” The engineer replied calmly. He went on to explain, “There isn't any perfection in engineering terms. We have to factor in deviations.” That impressed the boss.
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The 3rd candidate was an accountant. He too was asked the same question
with the same manner, “WHAT IS 2 PLUS 2?” The accountant did not respond. Instead he slowly moved towards the boss and asked softly, “What number would you like it to be?”
The lesson: Numbers can be manipulated.”
Sean laughed at the story and commented, “Interestingly, creativity is sought after in most industries except accountancy.”
“You are right, sonny. And it is our responsibility as business buyers to do our own checks. Are there plenty of honest accountants and management around, but we want to do our own checks.
You see, Return on Equity is becoming a popular criterion for investors to check the profitability of businesses. Thus managements are motivated to reflect a higher Return on Equity to attract investors. The best way to do this is to make more profits with the given amount of equity. Unfortunately, there is another way to go about it.”
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“Exactly. And this is not healthy.” The old man stated. He began to draw on a piece of paper to illustrate this.
Every business needs a certain amount of assets to operate and function. These assets can be cash, equipments, furniture etc. And these assets are either supported by the use of the business equity, which belongs to the owners of the business, or liabilities, which are debts the business owes.
Take for example, a business that requires $1 million of resource to operate, and it is financed by $300,000 of equity and $700,000 of liabilities.
This business makes a profit of $30,000 this year. Its ROE will be $30,000 divided by $300,000, which makes it 10%
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And if a business choose to shrink equity, not because it has become more efficient and needs less resources, but is doing so just to manipulate the figures to make its Return on Equity higher, they have no choice but to increase liabilities. So imagine the business shrink its equity to $150,000 by issuing out dividends. But the fact is the business still requires $1 million of resource to function. It can only do so by increasing its liabilities by $150,000.
But with the decrease in equity, the ROE figure is now very different. ROE is now $30,000 divided by $150,000, making it 20%, instead of the previous 10%.
“Wow, cool. It is like magic. And that is why the accountant can ask what number the boss wants. But is there anything detrimental about shrinking equity and increasing liabilities?”
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“The cost of debt is interest rate and that can be very costly. The cost of equity on the other hand is naggy owners, which is sometimes, very pressurizing and irritating, that is all. But for a business, they have to act in the best interest for the owners. Period.”
“I will love for you to run my businesses. You have such strong principles!” Sean praised the old man.
The old man laughed. Sean laughed with him.
“Well sonny, in order to not let creative accounting and management fool us into believing the business is efficient, we need to do some cross checking. In this case, we will cross check that the Return on Assets is high as well. The Return on Assets must be at least more than 7%. If the Return on Equity is consistently high, but the Return on Assets is not high, it may not mean that the business is efficient.”
136 Author’s Note:
Return on Assets (ROA)
The Return on Assets shows how profitable and efficient the business is in generating income with the amount of assets it has.
Return on Assets = Net Income Total Assets
For example, ABC Company made $100,000 this year. It has $300,000 in equity and $700,000 in liabililties.
ABC has a total asset of $300,000 (Equity) + $700,000 (Liabilities) = $1,000,000. The Return on Assets for ABC = $100,000 = 10%
$1,000,000
As a gauge, we want to find businesses that have high Return on Equity and high Return on Assets.
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