ROI (return on investment) and ROE (return on equity) are strong indicators of your business's overall health and performance. That information can be used to build your business strategy and improve the financial performance of your small or medium-sized business.
Calculating ROI and ROE
Simply put, ROI is the financial return of a company's investment in a revenue-driving strategy. Suppose you want to investigate the return of your spending on digital advertising or your expenditures on R&D. In that case, the ROI formula can let you know if that was a financially sound decision.
Let's take the example of a small restaurant. Suppose they want to begin investing in a digital marketing campaign and decide to spend $20,000 on creating social media ads to drive new customers to the restaurant.
At the end of their campaign, they attribute $60,000 in sales to this campaign. To calculate ROI, you plug the figures into the formula.
For this case, it will look like this [ ($60,000-$20,000) / $20,000 x 100 ] , so that's a 200%. ROI. Now they can take this figure, compare it to their other strategies, and see which brings in the most return on their total investment. And then double down on the most financially viable strategy.
ROE measures profitability against shareholder equity. This provides a clear picture for a business' investors if the management can utilize a company's assets to drive topline and bottom line revenue and generate a healthy return for each investor.
Let's revisit our small restaurant. Suppose they have $100,000 in shareholders’ equity, and their net income for the previous financial year was $25,000. You can get the ROE by dividing net income by shareholder's equity. Plugging these figures back into the ROE formula, we get ($25,000/$100,000) x 100, 25%. Once again, an investor can compare this to the industry average and decide if it's financially worth investing in the restaurant.
ROI vs. ROE to determine investment profitability
While both ROI and ROE clearly show a company's financial health, you cannot use them interchangeably. There is a crucial difference between the two. Your company's priorities will determine which one is more crucial, however.
If you want to determine if you made the right, wrong, or even a brilliant investment in a revenue-driving activity, ROI will be more relevant to you.
However, ROE is generally seen as a more accurate measure of a company's profitability as it considers its net income. At the same time, ROI only looks at the return on investment, and the company's equity capital is not considered. The return on shareholders' equity ratio is the net income divided by the shareholders' equity. The return on assets ratio is the net income divided by the total assets.
This means that ROE can compare different investments and help companies make sound financial decisions to improve their financial health and performance. However, ROI is still a fundamental metric for companies, as it shows their investments' efficiency. Generally, a higher ROI is better, but it is essential to consider all the factors involved to make an informed decision.
Whatever your priorities, it's critical to understand both ROI and ROE. You may learn a lot from these measures about your company's success. Understanding them can help you make better decisions about where to back your money and how to grow your company.
Improving your ROI and ROE
Understandably, business owners are always looking to improve their ROI. They have to ensure that all monetary and time investments pay off. The closer you pay attention to where your money is going and how your time is spent, the better decisions you will make and the more profits you'll see. To improve your return on investment, try one of the following.
Take another look at your sales data.
If you're investing a lot of time and effort into sales, you should measure how much money comes in from your sales activities and what they cost you. Take a second look at essential metrics like your ARR, ARPU, Churn, and CAC.
Also, talk with your sales team. They are on the front lines and will have better insights. They see things you might not, and their advice can make a huge difference.
ANALYZE and improve your digital content
Writing online content is an integral part of every company's strategy. However, if you want to improve your ROI from your content strategy, you must track the KPIs of each piece of content. The KPI will vary based on the goals of each range (awareness, consideration, conversion).
Track your KPIs, analyze what's helping you achieve your KPIs and what can be improved, and then make those tasks your priority.
Make your employees happy.
If you have invested much money into hiring and retaining talent, ensure they're engaged and happy at work. Happier employees are more productive; by extension, you will get a good return on initial investment. It's essential to remember, however, that ROI should not be the only factor you consider when you want to make your employees happier, you should do it because it is the right thing to do.
Your ROE is made up of your Net Income and Shareholder's equity. You will likely see a higher ROE if you can improve any of the two.
Improving shareholder's equity
Your shareholder's equity is derived by subtracting your total liabilities from your total assets. Paying off your liabilities or gaining assets will improve your shareholder's equity.
Improving your net profit
To increase your company's net income, you can either reduce expenses or increase revenue (or both). Since Net Profit is another part of the ROE equation, improving your Net Profit is another method to get a high ROE.
- Increase revenue: This will naturally increase your ROE as it is one factor that determines it.
- You can increase your product price.
- You can try cross-selling or upselling.
- Decrease costs: This will also help to increase your Roe as it will raise how much profit you are getting while keeping costs low.
- You can negotiate costs with suppliers.
- You can reduce operational costs.
- You can reduce labor costs.
Improving the above two metrics will improve your ROE. However, remember that you cannot improve what you do not measure.
Calculating ROE and ROI enhances a business owner to make sound financial decisions for their company.
Also, remember that potential investors will look at your ROE before adding your company to their investment portfolio.
ROI and ROE in an investment portfolio
A company must calculate return on investment (ROI) and return on equity (ROE)
ROI measures if it's worth pursuing a revenue-generating activity, and ROE measures your company's profitability. Both figures are an indication of the overall financial health and performance of your company.
You will learn a lot about your company from looking at these metrics, and so will (potential) investors. Do not forget that investors use your financial statements to make an investment decision and will tend to avoid businesses with low ROI and ROE. For an investor, that translates to lower investment profitability if you do not track and improve them. You're likely not able to get further investments for your company.