Return on investment, or ROI, and return on equity, or ROE, are ratios that provide two different ways to assess profitability, typically of a business. The two approaches measure different things and return different answers. Higher percentages for both tend to indicate a healthier business, but total debt plays a role in ROE and in more specific calculations of business health.
Return on Investment
ROI refers to how much money is made from a specific investment. A standard method of calculating ROI is to divide after-tax profits by total assets or, in the case of a project, after-tax profits divided by total investment. If a project calls for a $40,000 total investment and yields a $9,000 after-tax profit, the ROI comes to 22.5 percent. Standard ROI calculations do not account for debt and can give a false impression of business health.
Return on Equity
ROE refers to how much money is made on the basis of an individual’s total ownership stake. A standard method of calculating ROE is to divide after-tax profit by equity or an individual’s total stake. For example, an individual who invests $20,000 in the $40,000 project divides $9,000 after-tax profit into her $20,000 stake for a 45 percent ROE. The higher the debt incurred to finance a project or business, the lower the ROE. Single-digit ROE percentages often signal poor business health.