We have evaluated effectiveness, and we have assessed endurance. It is now time to measure the ultimate goal of business: creating value for the owners. Let us take a look at Return on Investment (ROI) and see just how hard the company's money is working for them.
Anytime a business spends money, whether they are purchasing new software, opening a new store location, or bringing on a new team, they are making an investment. As a manager, you must demonstrate that the investment has generated a return.
ROI is a universal metric used to evaluate the efficiency of a specific investment. It answers the question: For every dollar I put into this project, how much extra profit did I get back?
\[ \text{ROI} = \frac{\text{Net Profit from Investment}}{\text{Cost of Investment}} \times 100\text{%} \]If you invest $10,000 in a marketing campaign and it brings in $12,000 worth of new profit, your ROI, or Return on Investment, is 20% (($12,000 - $10,000) / $10,000). If the ROI is negative, the project reduces value.
Where ROI analyses specific projects, ROE evaluates the entire company from the owner (or shareholder) perspective. Recall the Balance Sheet from Chapter 1. The owner's stake is equity. ROE informs the shareholders about the percentage return generated by the CEO using their funds.
\[ \text{ROE} = \frac{\text{Net Income}}{\text{Shareholders' Equity}} \times 100\text{%} \]Investors absolutely love ROE. If investors can earn 5% interest in a bank account, then they will expect the company to deliver 15% or 20% ROE. This is because they want to be compensated for taking the risk of doing business.
Great Job! You have become familiar now with the three main categories of ratios, which are Profitability, Liquidity, and Return on Capital. You are now able to read financial statements effectively. In Chapter 4, we will switch from the past (Financial Statement Analysis) to the future with Budgeting. To conclude Chapter 3, let's do a few more exercises.