At first glance, return on investment and return on equity seem to mean the same, but they don't. Each one is a different calculation and has a different use. They are both financial indicators of business health and performance that small-business owners can use to improve the performance of their companies.
To conduct an ROI/ROE analysis, you need to decide which method is more appropriate. Look at each method and see how each is used to analyze investments.
What Is Return on Investment?
Return on investment is the financial benefit that results from making an investment or spending money on something. This ROI metric is extremely versatile and can be used to analyze the returns, for example, from marketing campaigns, investments in equipment, or monies spent on training programs for employees.
The formula for calculating an ROI as a percentage is:
ROI = (Net Return/Cost of Investment) X 100
To illustrate, suppose a company spends $100,000 on a marketing and advertising campaign for a new product. Over the next year, sales of this new product total $130,000, which provides a gross profit of $30,000.
The ROI for the marketing and advertising campaign is:
ROI = (Gross Profit/Campaign expense) X 100 = ($30,000/$100,000) X 100 = 30%
Is this a good ROI, or is it not enough? That depends on management's expectations. Is this campaign being compared with other marketing programs or other possible uses of the money? If so, then making an ROI calculation for each alternative is a good way to determine the best use of the company's funds.
What Is Return on Equity?
Return on equity is a financial ratio that measures the percentage return of the net income for a business on its shareholders' equity.
The formula to calculate the percentage ROE is:
ROE = (Net Income/Shareholders' Equity) X 100
In this case, shareholders' equity includes the contributed value of the company's common and preferred stock plus the accumulated retained earnings. ROE measures how well a company's management is using its assets to generate profits and provide a reasonable return to its shareholders.
Suppose a company has a total stockholders' equity of $600,000, and it generated a net income of $90,000 the previous year. The ROE is:
ROE = ($90,000/$600,000) X 100 = 15%
Whether this ROE is good or bad depends on a comparison of the company's ROE to industry averages of similar companies.
For reference, the long-term average ROE for Standard & Poor's 500 is 14%. Any ROE less than 10% would likely be considered inadequate by investors, whereas an ROE of 20% would be viewed as exceptional.
What Is the Difference Between ROI and ROE?
ROI can be used to determine the return on a wide range of investments. You can use ROI to calculate the return of your increase in productivity by adding an administrative assistant to your office, a change in price strategies, additional inventory investment or the purchase of a new machine.
ROE is a specific application of ROI. ROE is the net income return of the business to its total shareholders' equity; it isn't used for other more general purposes.
ROI and ROE are useful tools to evaluate the effectiveness of just about any type of expense. A small-business owner should be concerned about the return for all kinds of investments. After all, the end goal of any business is to achieve a reasonable return on capital. Otherwise, you have to look at other investments that generate better returns.