Thread by @FinsenseG

Thread: Whether DEBT is Good or Bad for a Company?
Find out:

3 important things:
1) Return on Capital Employed(ROCE)
2) Return on Equity(ROE)
3) Cost of Debt(Kd)

@RJGyanchandani @adi2five

1) ROCE is a measure of company's profitability vs its total capital.
ROCE = (EBIT/Captial Employed)
EBIT: Earnings Before Interest and Taxes
Capital Employed = Equity+Preference+Debt+Reserves

2) ROE is a measure of shareholder's profitability vs equity capital.
ROE = (PAT/Shareholder's Funds)
PAT: Profit After Tax
Shareholders Funds = Equity+Preference+Reserves

3) Kd (Cost of debt) is the interest rate at which the company has borrowed money
Kd is basically interest on debt. But, interest on debt is tax deductible, so if company has borrowed money at 10% and company pays tax at 30% then the cost of debt is not 10% but 7%.

Calculate the effective cost of debt by simply dividing Interest expense in Profit and Loss account by total long-term borrowings.

Now. In order to maximize returns for shareholders, Company has to ensure that its ROCE > Kd. This will lead to higher ROE (Return for Shareholders)

That means if the company is able to invest money in business which generates the return higher than its Cost of Debt, It is going to boost ROE (Return of Shareholders).
How? Let's take an example:

As you can see, Since the ROCE > Kd, The ROE is higher in the case where company has debt. That means debt is GOOD.

However if ROCE < Kd, Then debt will destroy shareholders returns.
Here is an example of how Debt can destroy ROE.

As you can see, Since the ROCE < Kd, The ROE is lower in the case where company has debt. That means debt is BAD.

Conclusion: Not every company with debt is Bad, it is important to check Earnings & whether ROCE is greater than the Cost of Debt. If that is so, Debt can actually boost returns for shareholders as it will have favorable effect of leverage and Vice Versa.