Introduction
Accounting ratios are an essential tool for financial statement analysis. A ratio is a mathematical number calculated with reference to the relationship between two or more numbers and may be expressed as a fraction, proportion, percentage, and several times. When the number is calculated using two accounting numbers derived from the financial statements, it is termed an accounting ratio.
Accounting ratios exhibit a relationship, if any, between accounting numbers extracted from financial statements, they can be defined as derived numbers, whose their efficacy depends a great deal upon the raw numbers from which they are calculated. Hence, if financial statements have some errors, the derived numbers in terms of analysis of ratios will also present an erroneous data. Also, ratios must be calculated using numbers which are meaningfully correlated. A percentage calculated by using two unrelated numbers would hardly serve any purpose.
Two significant ratios return on equity and return on investment. Both the ratios measure very similar concepts but with a slight difference in their underlying formulas. Both are used to decipher the profitability of a company based on the money it had to work with. This article attempts to define both ratios and explain the significant differences between the two.
Return on Equity vs Return on Investment
The critical difference between the return on equity and return on investment is that return on equity is mainly used to distinguish the profit level of the companies from investments, while return on investment focuses on clearing the profits of the firm. Return on equity provides an idea of profits from shareholder funds. On the other hand, return on investment gives an idea of how much of the acquisition was successful. The denominator for return on equity is shareholders' funds, while the denominator of return on investment is the cost of the investment. The numerator for return on equity and return on investment is the net profit earned. High return on equity shows improved managerial performance of the company. A high return on investment indicates the profitability of the investment made. Return on equity indicates the effectiveness of quantitative and qualitative factors, while return on investment indicates only the efficacy of quantitative aspects, i.e., it ignores the qualitative factors. For a company that runs on debt, return on equity will be higher than usual, while return on investment will be lower than normal. Return on equity indicates how much income has been generated with reference to shareholders’ funds Return on investment indicates how much revenue has been generated with respect to the cost of assets.
Difference Between Return on Equity and Return on Investment in Tabular Form
Parameters of Comparison | Return on Equity | Return on Investment |
Meaning | Return on equity is the ratio that provides information about the income of the firm as well as its shareholders’ funds. | Return on investment is the ratio that gives information about a firm's income and the value of its assets. |
Formula | The formula for calculating return on equity ratio is net income/shareholders' funds | The formula for return on investment is the net income/ cost of the investment |
Indicator | Return on equity indicates how much income has been generated with reference to shareholders' funds. | Return on investment indicates how much income has been generated with respect to the cost of assets. |
Loan of the company | If the company is running on high debt, then the return on equity will be higher than usual. |
If the company is running on high debt,
Then, the return on investment will be lower than usual. |
Qualitative indicator | Return on equity measure qualitative indices like organizational improvements as well. | Return on investment does not measure qualitative factors; it focuses only on quantitative aspects of the business. |
Effect of a higher ratio | A higher return on equity indicates improvement in management. | A higher return on investment only indicates better profitability of the enterprise. |
Debt factor | The debt factor is not given any importance in the calculation of return on investment. | The debt factor is considered while calculating return on investment. |
What is Return on Equity?
This ratio is significant from shareholders' point of view in assessing whether their investment in the firm generates a reasonable return or not. It should be higher than the return on investment; otherwise, it would imply that the company's funds have not been employed profitably.
The return on equity is a two-port ratio meaning it provides information about the income of the firm as well as that how much profit is earned from the shareholder's equity. If a company can maximize the profit from the shareholder's equity, the position of the firm in the upcoming years will rise at a reasonable rate. It also provides an analysis of the investment to the profit earned from the asset or the number transformed from investment to profit.
How to calculate Return on Equity?
Return on Equit is expressed as a percentage and can be calculated for any corporation if both net income and equity are positive numbers. Net income is calculated before dividends are paid to the common shareholders and after dividends to preferred shareholders and interest to lenders.
Return on Equity = Net income/ Shareholders equity
How is the return on equity related to stock performance?
Sustainable growth rates, as well as dividend growth rates, can be estimated using Return on equity; despite various challenges, return on equity can be a good starting point for developing future estimates of a stock's growth rate as well as the growth rate of its dividend. These two ratios are functions of each other and can be used to make an easier comparison between similar companies.
To estimate a company’s future growth rate, an investor may multiply the return on equity of the company by its retention ratio. The retention ratio of a company is defined as the percentage of net income which is reinvested or retained by the company to fund future growth.
Is the return on equity good if it is high?
Quite often, an extremely high return on equity is a good thing if net income is substantial compared to equity because a company's performance is solid. However, an abnormally high return on equity is often due to a small equity account compared to net income, which indicates risk. Such a situation may result due to the following reasons:
- Inconsistent profits - If a company has been suffering losses continuously, these losses would have been added to the equity (as losses incurred) as a negative figure which would reduce the equity amount consistently. When such a company suddenly earns a profit in a year due to any reason, the return on equity will be high, as net income will be a more significant amount than equity as the amount of equity would have deteriorated over the years due to consistent losses.
- Excess debt - A company that has excess debt will have a lesser amount of equity, as equity is calculated as assets minus debt. This generally occurs when a company borrows high amounts to buy back its own shares. In such a situation, the return on equity of the company will be increased, as equity will be low. However, this high return on equity will not have a significant effect on the company's performance or growth.
What is Return on Investment?
Return on investment is a business term used to identify past as well as future financial returns. Managers and executives study the return on investment of a venture as it measures and indicates the success level of the venture. The formula for calculating the ratio of return on investment is Net income/ cost of acquisition.
Importance of return on investment for a business
It is crucial for a business to measure the return on its investment, as it indicates the profits generated by the asset. So, if the return on investment is not close to the optimal value, then it means that the investment is likely dead. Hence, the company must either focus on improving its status so that the investment does not sit idle and necessarily add on to its costs or must sell it.
Benefits of Return on Investment
- Help in analysing short and long-term projects: Targets may be set for both short-term and long-term goals, and return on investment can measure if the company achieves those benchmarks effectively and efficiently.
- Helps evaluate a firm's financial performance: Knowing your return on investment keeps the company on track by demonstrating whether the company is profiting above or below its industry norms and standards. It is a reminder for companies to set and maintain a particular standard for their finances.
Limitations of Return on Investment
- Not an indicator of cash flow position: Return on investment ratio is not an ideal indicator of the cash flow position of the company. A company may have a high return on investment ratio but may be short on cash. Hence, it cannot ensure that the company has generated sufficient net cash flow.
- Changes in future expenses: Return on investment is estimated assuming future business expenses. There may be some changes in the same in the future. This renders the ratio useless. Hence, future costs must be estimated carefully. But there is no guarantee of an unchanged business environment.
- Return on investment ignores qualitative aspects: It does not measure qualitative factors like improvement in management or employees' hard work. E.g., the Upgradation of computers may not have a direct financial benefit for the company. However, it improves employee motivation and performance, although the return on investment does not consider such parameters.
Main Differences Between Return on Equity and Return on Investment In Points
- The base for calculating return n equity is shareholders' funds, while the base for calculating return on investment is the cost of the investment.
- The formula for return on equity is net income/shareholders funds. The formula for return on investment is net income/ cost of acquisition.
- Return on equity is an indicator of the amount of income generated with respect to shareholders' funds. Return on investment indicates the amount of revenue generated with respect to the cost of investment.
- If the company is running on high debt, return on equity will be higher than usual, while return on investment will be lower than usual.
- Qualitative instruments like good management and improved performance are realised by calculating return on equity. Qualitative instruments are not considered while calculating return on investment.
- A higher return on equity indicates improvement in management, while a higher return on investment only indicates higher profits.
- The debt factor is not given importance while calculating return on equity, whereas the debt factor is considered while calculating return on investment.
Conclusion
Accounting ratios are an significant tool for financial statement analysis. A ratio is a mathematical number calculated with reference to the relationship between two or more numbers and may be expressed as a fraction, proportion, percentage, and several times. Two such ratios used to ascertain the profitability of a firm are return on equity and return on investment. Both the ratios measure very similar concepts but with a slight difference in their underlying formulas. Both are used to decipher the profitability of a company based on the money it had to work with. Although the numerator for both the ratios is net income, their base differs. Return on equity is calculated upon shareholders' funds, while return on investment is calculated upon the cost of investment. While return on equity shows the net income earned by a company in relation to shareholders' funds, return on investment shows the net income earned by a company in relation to the initial cost of the investment. This article has attempted to draw the differences between the two. Further, it has also explained the concept of return on equity and its relation to stock performance and that a higher ratio need not necessarily indicate better performance. It has also explained the concept of return on investment and its benefits and limitations. This article has covered the key differences between return on equity and return on investment in a tabular form and in points.
References
- Class 12 NCERT Accountancy Volume-2
- www.groww.com