Return on Investment and Return on Equity
Business Arithmetic — how well the total money works, how well your own money works, and what EBITDA reveals
Return on Investment (ROI)
RETURN ON INVESTMENT
ROI = (Net Profit / Total Capital Invested) × 100
Solved Example
Problem
Investing ₹ 100,000 in a grocery shop yields ₹ 20,000 net profit in one year. The owner invested ₹ 40,000 (equity) and borrowed ₹ 60,000 (loan), so total investment is ₹ 100,000. Calculate ROI.
Solution
ROI = 20%
Return on Equity (ROE)
RETURN ON EQUITY
ROE = (Net Income / Equity) × 100
Solved Example
Problem
Grocery shop: owner's equity = ₹ 40,000; loan = ₹ 60,000 at 10% interest; annual interest = ₹ 6,000; net profit before interest = ₹ 20,000. Calculate ROE.
Solution
ROE = 35%
Reading the percentages
ROE of 35% means for every Rupee of own money invested, the owner made 35 paisa net income. ROI of 20% means for every Rupee of total capital (equity + loan) invested, the business yielded 20 paisa average profit.
ROI vs ROE — The Leverage Effect
Two identical businesses, A (all equity) and B (part loan), with identical operations. Interest rate is 10%.
| Aspect | Business A — All Equity | Business B — With Loan |
|---|---|---|
| Total investment | ₹ 10,00,000 | ₹ 10,00,000 |
| Equity | ₹ 10,00,000 | ₹ 4,00,000 |
| Loan | — | ₹ 6,00,000 |
| Sales revenue | ₹ 7,00,000 | ₹ 7,00,000 |
| Gross margin | ₹ 4,00,000 | ₹ 4,00,000 |
| Interest | — | ₹ 60,000 |
| Profit before tax | ₹ 1,40,000 | ₹ 80,000 |
| Profit after tax (20%) | ₹ 1,12,000 | ₹ 64,000 |
| ROI | 11.2% | 6.4% |
| ROE | 11.2% | 16% |
Business B has lower profit and lower ROI (6.4% vs 11.2%) — but higher ROE (16% vs 11.2%) because less own money backs the same engine. ROEshows how effectively “own money” is used; ROIshows how effectively “total money” is used.
Leverage cuts both ways
If profit before interest had been only ₹ 60,000, interest of ₹ 60,000 would leave zero — ROE would collapse. Debt magnifies returns in both directions; the loan only helps while it earns more than it costs.
EBITDA
EBITDA (FROM NET PROFIT)
EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortization
EBITDA (FROM PBT AFTER D&A)
EBITDA = Profit before interest & tax (after D&A) + Depreciation + Amortization
Why EBITDA matters
EBITDA measures a business's ability to generate cash from operations. Business value is often quoted as a multiple of EBITDA, reflecting expected future cash flows — that is why headlines say “Zomato trades at 40× EBITDA”.
Key Takeaways
Key Takeaways
- ROI measures profit relative to total capital invested (equity + loan); ROE measures profit relative to the owner's own equity.
- ROI = (Net Profit / Total Capital Invested) × 100; ROE = (Net Income / Equity) × 100.
- Leverage: a business with a loan can have lower ROI but higher ROE — own money is used more effectively.
- ROE tells you how effectively "own money" is used; ROI tells you how effectively "total money" is used.
- EBITDA = Earnings Before Interest, Taxes, Depreciation and Amortization — a measure of operational cash generation.
- So what? — When a relative asks "what did your shop actually earn?", the honest answer is the ratio, not the profit number.