#10: When does debt destroy ROE

The other day, we were brainstorming a new loan product.

I had built a financial model from scratch based on the assumptions we had agreed on.

While reviewing the P&L, my CEO paused and asked a simple question:

"Why is ROE falling in the later years?"

"Because we're introducing debt," I said.

She replied, "But debt magnifies ROE, right?"

That sentence sounds obvious. But it's incomplete.

Debt can magnify ROE. But it can just as easily destroy it.
And this distinction matters more than most people realize.

Let me explain the framework I use to think about this. It applies to lending businesses, but also to any business that uses leverage.

First, remove debt from the picture

Before talking about leverage, ask one basic question:

What does the business earn on its own capital?

Strip the business of debt and look at operating economics alone.

A simple way to express this is:

Pre-debt return = Operating profit ÷ Capital employed

Operating profit here means profit before interest.
Capital employed is the equity (and any permanent capital) required to run the business.

In a lending business, this usually comes from:

Loan yield
minus credit cost
minus operating expenses
minus tax

What's left is your pre-debt ROA or ROE.

This number tells you whether the product is fundamentally strong or weak.

For any other business, simply use Net Operating Profit after Tax (NOPAT). That is Profit after Tax plus Interest (1- tax rate). This NOPAT divided by Capital employed is oyur answer here.

Now introduce debt

Once you know what the business earns on its own, introduce debt at a cost.

Here's the rule that never changes:

• If pre-debt return > cost of debt, leverage increases ROE

• If pre-debt return = cost of debt, leverage does nothing

• If pre-debt return < cost of debt, leverage reduces ROE

Debt does not magically improve returns.
It simply amplifies the spread between what the business earns and what debt costs.

This rule applies everywhere:
manufacturing, real estate, SaaS, retail, and lending.

There are no special exceptions.

Note cost of debt is post tax because we have taken Operating margin after tax as benchmark.

Why ROE often falls in later years

This is where many financial models start "misbehaving" in people's minds.

In early years:

• The balance sheet is equity-heavy

• Interest cost is low

• ROE largely reflects operating performance

In later years:

• Debt is added to fund growth

• Interest expense becomes material

• If product economics haven't improved, ROE starts falling

So when someone says, "ROE is falling because of debt," that's not a modelling error.

It's the model telling you something uncomfortable but important:
the business is borrowing at a rate higher than what it earns.

Why this is especially dangerous in lending businesses

Lending businesses are particularly prone to this confusion.

Why?

• Loan yields look attractive upfront

• Credit costs show up with a lag

• Opex often scales faster than planned

• Cost of borrowing rarely falls as optimistically assumed

It's very common to see situations like this:

• Pre-debt ROA of 6 – 7%

• Cost of debt at 8 – 9%

On paper, the business "works" with equity.
The moment leverage is added, ROE starts getting compressed.

That's not bad luck.
That's math.

The real takeaway

Debt is not a growth engine by default.
It is a return amplifier.

Before asking:

"How much leverage can we take?"

Ask this instead:"What does this product earn before leverage?"

If the answer is not comfortably above the cost of debt, leverage will hurt you over time, even if growth looks impressive.

Once you internalize this framework, falling ROE stops being confusing.
It becomes a signal.

And good models exist to surface signals, not to hide them.

For interested few who wish to deep dive into this concept (for lending business) I have simple single loan product profitability model for you. Feel free to play around with your assumptions.

ᐧ