PROFITABILITY RATIOS
Return on Investment (ROI)
ROI measures how much profit is earned from the money invested in the business or in a
project. It shows the efficiency of an investment — in other words, how well the investment
“paid off.”
Formula:
ROI = Net profit / Amount Invested x 100
Example:
A business invests $50,000 in a project and earns a net profit of $10,000.
ROI = Net profit / Amount Invested x 100
ROI = 10,000 / 50,000 x 100
ROI = 20%
This means that the business earned a 20% return on its investment.
A higher ROI means the investment is more profitable
A lower ROI means the investment may not be worth the cost or risk
Return on Capital Employed (ROCE)
ROCE measures how efficiently the total capital invested in the business (both owner’s and
long-term borrowed funds) is being used to generate profit.
It focuses on the overall profitability of the business, not just one investment.
Formula:
ROCE = Net profit before interest and tax (operating profit) / Capital Employed x 100
Where:
Capital Employed = Total Assets – Current Liabilities or Owner’s Capital + Long-term Liabilities
Example:
Operating Profit = $40,000
Capital Employed = $200,000
ROCE = 40,000 / 200,000 x 100
ROCE = 20%
This means that the business earns 20% return on total capital employed.
Interpretation:
Higher ROCE → The business is efficiently using its capital.
Lower ROCE → The business is not generating enough profit from its resources.
CLASS QUESTION:
A business owner deposited $125,000 into a 3 year investment plan with ABC Investment
Company. At the end of the 3 year investment plan, he will receive the original amount
invested with annual interest for each of the 3 years.
Year
Interest rate payable per annum (%)
1
2%
2
4%
3
6%
a) Calculate the average percentage rate payable over 3 years?
b) Calculate the dollar amount of interest earned by the business owner at the end of the
3 year period.
c) Calculate the total amount payable to the business owner upon maturity of the
investment.
d) Calculate ROI for the 3 year period.
e) Explain the meaning of ROI to the owner
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