Today I want to speak more about the concept of thinking about how debt fits into your business as an investment.
In an earlier post, I explained the importance of thinking of your business as an investment, and we’ve talked about how debt is a tool used to leverage the equity in your investment. There are two metrics that present a clear picture of how leverage is helping your business.
The first measure is your Return on Assets (ROA). This is a simple calculation using your profit at the end of the year divided by the total assets of your company. The ROA is used to tell you how efficient your business is. The other metric used is called Return on Equity (ROE). It’s calculated by using your profits and dividing by the equity in your business, meaning that all the liabilities on your balance sheet are deducted. If you don’t have any debts, your ROE will match your ROA.
As you take on liabilities, your ROE will expand.
For example, let’s say you start with $100,000 in assets, zero liabilities, and have a net profit of $10,000. This gives you an ROA of 10% and an ROE of 10%. The next year, you’re to borrow $100,000. Now your company is twice as big as it was before and you’ve earned $20,000 off of those $200,000 in total assets. Your ROA stays the same at 10% but your ROE is 20% – it doubled!
With the proper leverage, not only will your profits increase in terms of the actual dollar amount (remember that you’re doing twice as much with the debt), but after paying off the interest of the debt, the rest of those new profits come straight to you.
Professional investors always look at your ROE first. This includes investors in Fortune 500 companies as well as those who invest in smaller businesses. ROA and ROE will help you understand the role of leverage on your bottom line and give you a sense of whether you are managing your debt properly.
Understanding how debt works as an investment gives you the opportunity to make the best decisions possible for your business.
