Your client tells you that there seems to be confusion around the definitions of

Question

Your client tells you that there seems to be confusion around the definitions of ROI and ROE, and how these terms are applicable to his manufacturing company. First, describe both terms and why knowing these terms are important to his company. Second, your client asks you which of the following are sources of funds and which are uses of funds: (a) sale of land, (b) dividend payments, (c) decrease in accrued taxes, (d) decrease in raw material inventory, (e) depreciation charges, and (f) sale of government bonds. Now go back and identify which items would appear under either the operating, investing, or financing activities sections of a cash flow statement using the indirect method.

Explanation / Answer

ROI
Return on investment equals the net income from a business or a project divided by the total money invested in the venture multiplied by 100. If, for example, you spend $100,000 to open a groceries store and make a net profit of $15,000 in one year, your annual ROI equals $15,000 / $100,000 x 100 = 15 percent. When calculating ROI, the investment will include not only what the investor spent out of pocket, but also all borrowed funds. In the example, the owner might have invested $60,000 out of pocket and secured a loan for $40,000.

ROE

You can calculate ROE by dividing the net income by the equity of the investor and multiplying the result by 100. In the example, the grocery store's owner has an equity stake of $60,000 in the business. So ROE equals $15,000 / $60,000 x 100 = 25 percent. This means that for every dollar of her own money the owner put into the business, she made 25 cents. The ROI of 15 percent, on the other hand, means that for every dollar of combined assets and loans invested, the business yielded a 15 cent average profit.
USES
ROI provides information about management's performance in using the resources of the small business to generate income. ROI and other financial ratios can provide small business owners and managers with a valuable tool to measure their progress against predetermined internal goals, a certain competitor, or the overall industry. ROI is also used by bankers, investors, and business analysts to assess a company's use of resources and financial strength.

ROE is an important measurement for potential investors because they want to see how efficiently a company will use their money to generate net income.ROE is also and indicator of how effective management is at using equity financing to fund operations and grow the company.

PART 2

Particulars Source/use of funds Type of activity Sale of land Source of funds Investing Dividend payment Use of funds Financing Decrease in accrued taxes Source of funds Operating Decrease in raw material inventory Use of funds Operating Depreciation charges NIL Operating Sale of government bonds Source of funds Financing

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