the-playbook.in

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 Ope...