Equity

For example, return on equity (ROE) is defined as .

As equity approaches zero, ROE approaches infinity. Therefore, when a board of directors emphasizes ROE as a performance measure, managers respond by minimizing equity and maximizing profits. To minimize equity, they avoid issuing stock and they pay dividends to reduce retained earnings. They match all investments with new debt (increasing debt, or leverage) . They work the assets hard (asset turnover) .

Therefore, if the board says, “emphasize ROE,” you can predict that the company’s financial structure will be at least 50%/50% debt to equity. It might be as high as 75%/25% debt to equity.

Let’s look at how the performance measures affect financial structure by examining each measure as if they were the only one selected for the company. Examining the extremes can provide insight into the usefulness of each measure.