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Dear Tutor Ken Garrett
This is actually a PM question (not APM) but looks like PM Ask Tutors page is not working at the moment..
BPP revision kit says the follow statement is true:
“The profit figure for ROI should always be the amount before any interest is changed”
I don’t understand why interest expense is excluded, is it to assess the profitability of asset in isolation?
Thank you!
A company could be financed in many ways, but in particular a mix of equity capital and loan capital.
First, assume 100% equity and no loans. You would work out ROI as profit divided by equity ie the return divided by the amount invested. This would be before dividends because di idends are simply a reward to the suppliers of capital. We are interested in knowing what rate of return is made on the capital ie how has the company performed with the money
Now assume a company almost entirely financed by loans with negligible equity. The investment is the value of the loans. Interest is the reward to the investors (instead of dividends). We are still interested on how well the company has done with the capital invested, so the equivalent calculation is profit before interest/amount invested ie profit before interest divided by loan amount. Interest is the reward to investors.
Most companies have a mix of finance but we are always interested in comparing the income generated to the amount of capital used and this will be before both interest and dividends.
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