This is a complete guide on how to calculate Return on Debt Ratio (ROD) with in-depth interpretation, analysis, and example. You will learn how to use its formula to evaluate a company’s profitability.
Definition - What is Return on Debt Ratio?
The return on debt (ROD), also known as the return on long-term liabilities, is a metric that measures that amount of profit a company generates in relation to the amount of debt it has on its balance sheet.
It is not a commonly used financial ratio. It is more often utilized in high-level financial modeling.
However, it can provide useful information on companies who are highly levered because it may show a company’s probability of defaulting.
The equation for calculating ROD is as follows:
Return on Debt = Net Income / Long Term Debt
As you can see, to compute the return on total long-term debt ratio, you simply take a company’s net income from its income statement, and you divide it by long term debt, which is found on the balance sheet.
A company’s rate of return on debt calculates how much money a it produces for every $1 dollar of debt it has.
In attempt to provide a better explanation of ROD, here is an example:
Suppose you have two manufacturing companies. One is Company CCC, and one is Company DDD.
Company CCC has $150 million of debt, and has a net income of $15 million. Company DDD has $500 million of debt, and has $15 million in net income as well.
Return on Debt
Inputting both companies’ financials into the equation above, we see that Company CCC has an ROD of 10%, and Company DDD has an ROD of 3%.
Interpretation & Analysis
The situation above is the prime example of when calculating the return on long-term debt can be beneficial to an investor.
By solely looking at the two companies’ net income figures, they seem comparable – both have $15 million in net income.
But when computing their respective RODs, the discrepancies between the two companies becomes clear. Company DDD has considerably more debt than company CCC.
It requires 233% more debt capital to produce the same amount of net income.
This can alert investors to avoid Company DDD, because when its debt comes due, it may not be able to pay it off.
Company CCC, on the other hand, is producing a healthy amount of net income in relation to the amount of debt it has on its balance sheet.
So, in this example, Company CCC is the seemingly more attractive investment.
Cautions & Further Explanation
Especially as a tool for investors, this ratio has its shortcomings. It can potentially give misinformation to investors.
For example, the formula does not take one-time expenses into account.
So even though a company’s earnings may be suppressed by a one-time legal expense, it will still appear as if the company is struggling to pay off its debt.
Additionally, it does not take a company’s cash balance into account.
So, a company could be sitting on billions of dollars, but because they had an unusually low net income this year, it may appear as if they will not be able to repay their debt.
Therefore, it is important to utilize many metrics before making an investment decision.
Though, if used correctly, the return on long-term debt can help an investor understand a company’s ability to pay back its liabilities.