ROI and ROE

The essentials

Profit in rupees alone does not show how well money has been used. Return ratios compare profit with the money invested.

• Return on investment (ROI) = net profit ÷ total investment (total capital employed) × 100. It measures how efficiently all the funds in the business, both owners' and borrowed, have been used.
• Return on equity (ROE) = net profit available to equity shareholders ÷ shareholders' equity × 100. It measures the return earned on the owners' own money.

For ROE, the profit taken is after interest on borrowed funds and after tax (and after preference dividend, if any), because those claims come before the owners.

Key points

• A higher ROI or ROE generally signals better use of funds, but compare with similar firms and with the cost of borrowing.
• Trading on equity (financial leverage): if a firm borrows at an interest rate lower than the return it earns on total investment, the extra earning goes to the owners, so ROE rises above ROI.
• If borrowing costs more than the firm earns, leverage reduces ROE.
• Entrepreneurs and investors use these ratios to compare projects and to decide whether to expand.

Exam tips

• Identify the denominator carefully: total investment for ROI, owners' equity for ROE.
• For ROE, deduct interest from operating profit before dividing by equity.

Common mistakes

• Dividing profit by equity when the question asks for ROI.
• Forgetting to deduct interest when calculating profit for equity holders.