Definition: A profitability measure that evaluates the performance of a
business by dividing net profit by net worth
Return on investment, or ROI, is the most common profitability
ratio. There are several ways to determine ROI, but the most
frequently used method is to divide net profit by total assets. So
if your net profit is $100,000 and your total assets are $300,000,
your ROI would be .33 or 33 percent.
Return on investment isn't necessarily the same as profit. ROI
deals with the money you invest in the company and the return you
realize on that money based on the net profit of the business.
Profit, on the other hand, measures the performance of the
business. Don't confuse ROI with the return on the owner's equity.
This is an entirely different item as well. Only in sole
proprietorships does equity equal the total investment or assets of
the business.
You can use ROI in several different ways to gauge the
profitability of your business. For instance, you can measure the
performance of your pricing policies, inventory investment, capital
equipment investment, and so forth. Some other ways to use ROI
within your company are by:
- Dividing net income, interest, and taxes by total liabilities
to measure rate of earnings of total capital employed.
- Dividing net income and income taxes by proprietary equity and
fixed liabilities to produce a rate of earnings on invested
capital.
- Dividing net income by total capital plus reserves to calculate
the rate of earnings on proprietary equity and stock equity.