March 12, 2025 l Business Mirror
What is the difference between Return on Investment (ROI) and Return on Equity (ROE)? Let us start with a few basic concepts of return, investment and equity.
Return is normally expressed as a percentage over a period of time. This rate of return can be though of as how much you get back in addition to the principal amount you invested.
For example, if your put funds into a time deposit with a bank, a principal amount of P1 million, and after one year you get an interest of P5,000 after final withholding taxes, your rate of return or simply return is 5,000/1,000,000 = 5.0 percent per annum or simply 5.0 percent.
The amount of P1 million is called your investment and, since you probably did not borrow the money to make this time deposit, this investment is entirely your money or your equity. In this case, where the investment is entirely in the form of equity, the ROI = ROE.
However, this is not always the case where investments are made in a project or business where some amount is borrowed. Let us say you decided to put up a business that needed an initial investment of P1 million but you only had P600,000 of your own money and had to borrow the balance of P400,000 from the bank, which is charging you 7.0 percent interest rate.
If this business after a period of 1 year gave you a net profit before taxes and interest of P100,000, your ROI would be 100,000/1,000,000 and your ROE would be (100,000-28,000)/600,000 = 12.0 percent.
The difference is that the denominator used in the ROI is the total investment while the one for the ROE is your total equity. Hence, when the cost of borrowing is less than or equal to the ROI, this will lead to a higher ROE. On the other hand, if the cost of borrowing is higher than the ROI, this will lead to a lower ROE since more of the return will be used to pay the higher interest rate. If in our earlier example the cost of borrowing is 15.0 percent, while the ROI will remain the same at 10.0 percent, the ROE will drop to (100,000-60,000)/600,000 = 6.67 percent!
There are also a number of complications that can be computed for, such as when periods or ten-ors are less than one year, compounding of interest rates, computing of rates of returns for the en-tire project life or investment periods covering several years necessitating an internal rate or return (IRR) or net present value (NPV). However, it would not be possible to discuss all of these in the space allocated for this column.
Our objective for now is to learn how to differentiate between ROI and ROE. It is also important to understand the repercussions of the cost of borrowing and its effect on the ROE.
Hopefully, this short column was able to provide you with the relevant knowledge to deepen your understanding of some basic financial terminology.
***The views expressed herein are his own and do not necessarily reflect the opinion of his office as well as FINEX. For comments, email georgechuaph@yahoo.com or gschua@up.edu.ph. Photo is from Pinterest.