Return on investment i.e. the earning power of a firm is the ratio of net profit to total assets.
Net profit is the residual income after providing for all the expenses. These expenses include,
- Cost of direct material, labour and variable expenses
- Operating costs like salaries, wages etc.
- Fixed costs like interest and taxes.
Return on investment can be improved by increasing the profit margin for the same volume of sales. Profit can be further improved by reducing costs. One of the elements of cost is interest payment.
One way of keeping the costs under control is by maintaining a proper balance between equity and debt.
Debt carries a fixed charge known as interest, which has to be paid irrespective of the amount of profits. Equity does not carry a fixed charge and can be paid from the net profits after allowing for all the expenses. The return to the equity holders i.e. payment of dividend is not a legal binding on the firm.
The interest on debt is tax deductible but the equity dividends are not tax-deductible payments. Hence a proper proportion of debt and equity can be used to improve return on investment.