One of the most practical discoveries by an entrepreneur is the profitability ratio, called return on investment or ROI. Unfortunately, the deployment of different methods for measuring ROI creates confusion. One of the common procedures for determining ROI is dividing profit by business assets. Another process is dividing by net assets, which is the equity capital of the enterprise. This ratio is usually called return on equity, or ROE.
Your business equity is assets minus liabilities. That is, take what the business has (such as cash and equipment) and subtract what the business owes (such as a loan or credit card debt). Say you have a basic service operation that has a computer that cost $600. But you charged the computer purchase on a company credit card and still owe $100. In addition, you keep $9,500 in a bank account to provide cash flow to pay expenses until customers pay you. The business assets are $10,100 ($9,500 plus $600), but the business equity is $10,000 ($9,500 plus $600 minus $100). When your business has a profit of $50,000, the ROI based on assets is 495%, and the ROE is 500%.
Obviously, capital-intensive businesses have much smaller ROI because they need more assets. These organizations may need $250,000 of assets to generate $50,000 of profit. That delivers a 20% ROI. Regardless of the type of enterprise you operate, tracking ROI or ROE uncovers your business trend. This is different than merely examining dollar profit. A rising profit can trigger lower ROI and ROE if you need much greater assets to attain that profit. This result signals potential trouble from insufficient resources.