Return on investment, or ROI, and return on equity, or ROE, are two critical profitability ratios. These measures are applicable to individual projects, such as the purchase and subsequent sale of a condominium, a small business or a multinational conglomerate. Therefore, it pays to understand ROE and ROI.
Return on Investment
Return on investment equals the net income from a business or a project divided by the total money invested in the venture multiplied by 100. If, for example, you spend $100,000 to open a laundromat and make a net profit of $15,000 in one year, your annual ROI equals $15,000 / $100,000 x 100, which is 15 percent.
When calculating ROI, the investment will include not only what the investor spent out of pocket, but also all borrowed funds. In the example, the owner might have invested $60,000 out of pocket and secured a loan for $40,000.
Return on Equity
You can calculate ROE by dividing the net income by the equity of the investor and multiplying the result by 100. In the example, the laundromat's owner has an equity stake of $60,000 in the business. So, ROE equals $15,000 / $60,000 x 100, which is 25 percent.
This means that for every dollar of her own money the owner put into the business, she made 25 cents. The ROI of 15 percent, on the other hand, means that for every dollar of combined assets and loans invested, the business yielded a 15 cent average profit.
Impact of Interest Expense
When the investment is fully funded by equity and there is no loan involved, the equity and total amount invested are the same. In such cases, the ROI and ROE are also identical. When a loan is involved, however, the ROE will be higher than it would have been without the loan if the additional profit made possible by the loan exceeds the loan's interest expense.
Assume you can invest $60,000 and open a small laundromat that will return a $12,000 annual profit. Or, you can borrow $40,000 more and open a far larger laundromat that will net $19,000 profit. You should borrow funds and run a larger business if the interest expense on the loan is less than the $7,000 additional profit made possible by the loan. If it is, your ROE will grow.
Risk of Borrowing
As a general rule, the more you borrow, the greater the potential loss. If the laundromat fails to attract enough customers to justify even a small 900-square-foot store you could have built with $60,000, and you are sitting on a 1,500-square-foot space and now must also pay the bank interest every month, you are looking at a disastrous scenario. Not only did a bigger business fail to yield more money, but now your costs for rent, upkeep and, most importantly, interest expense are far greater.
This is why borrowing funds to grow your operations is often referred to as leverage. Borrowed funds leverage, or magnify, profits if things go well, but they will multiply losses if things turn south.