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.