Return on Debt (ROD) is a helpful but often overlooked ratio utilized to determine how much profit a company is generating per every $1 of debt on its holds.
The ratio is certainly not as sexy or fashionable as Return on Equity (ROE) or Return on Capital (ROC) that are commonly used by most wall street professionals. However, it doesn’t mean the ratio doesn’t has its place or value. Since we tend to work with clients that are highly leveraged or are seeking to take on high amounts of leverage to complete a transaction, this ratio can come in handy for such situations.
According to Investopedia, it is more of an analytical tool rather than a return metric.
We’ll see below on how to calculate the formula and how this ratio could be helpful to analyze your company’s financial health.
Net Income / Long Term Debt
For example, Company A has roughly $1,500,00 debt with a net income of $100,000, therefore it’s Return on Debt (ROD) is roughly 6%. Keep this figure in mind for below.
Although there are no universally-held adjustments to the ratio, since it is albeit an uncommon used ratio, we have decided to make our own adjustments to the formula in order to produce a more accurate result.
Net Income / Long Term Debt – Nonrecurring Charges
Net Income = Prior Year’s annual net income
Long Term Debt = Includes all long term outstanding interest-bearing debt and loans
Nonrecurring Charge = It is reasonable to subtract one-time charges to prevent a distorted view of financials
If you are familiar with our approach and have reviewed some of our other material, we always to seek to ensure our clients are generating actual shareholder value. Whether its Return on Equity or Return on Debt, we always measure these figures against their arch nemesis – Cost of Equity or Cost of Debt. This is to see if real value is being generated from the capital that has been employed.
Let’s use our Return on Debt (ROD) figure from Company A example above. Now, let’s say that the firm’s cost-of-debt is 7%, which is higher due to the firm’s high leverage and current prevailing rates in the market. In simple English, this means the company is not generating any real value from its financial leverage. Imagine the Return on Equity since the cost of equity is always higher than the cost of debt. Not a good scenario.
The ratio can be measured on a historical analysis with the added adjustments from above to see how returns on debt are improving or not. This could be analyzed on either an annual basis or quarterly basis.
The ratio can also be used to measure the probability of a highly leveraged firm of defaulting on its debt, especially if the Return on Debt (ROD) is on a constant decline or is becoming lower than its cost of debt.
Another useful benefit of the ratio would be if it were used as a comparable metric with other similar competitors in your sector.
As mentioned above, the ratio is not as useful or universally-held as metrics such as Return on Equity (ROE) or Return on Capital (ROC) are, but it can be certainly useful if your company is highly leveraged or seeking to take on a high amount of leverage for a project. In other words, this ratio alone does not make or break a business.
See our other articles or be on standby for upcoming articles relating to Return on Equity, Cost of Equity and other similar metrics to further analyze the health of your business.
Please visit us at www.salembridgecapital.com for more information or contact us directly for a free consultation and guidance at (646) 926-4391.