Debt or leverage can skew a company's return on equity. Let's have a look at an example. Here we have company A and it's funded by 1,000 of equity. Let's have a look at part of A's income statements. It's got operating profit of 100, and because it's got no debt, it's only funded by equity. No debt means no interest. So profit before tax is just 100. Tax at 20% is 20, giving net income of 80. Now let's look at company B. Company B is funded by 700 of debt and 300 of equity. So it's still got 1000 of funding similar to company A. Interest rate on debt is 5%.

If we look at an extract of company B's income statements, it has the same operating profit as company A, they're comparable company's. But now because company B had 700 of debt, it needs to pay interest on that at 5%. That means it pays interest of 35. So profit before tax has now gone down to 65. It pays tax on that of 13, giving net income of 52.

So if I was just comparing the net incomes here, clearly company A is doing better, but when we compare return on equity, things look different. The shareholder's equity of company A was 1,000, but the shareholder's equity of company B was much lower at 300.

So when we calculate company a return on equity, we take it 80 of net income divided by the 1,000 equity that gives us 8%. Company B is very different. Company B's return on equity is the 52 of net income. So yes, that's lower, but divided by company B's equity of 300, much lower. The net impact is that company B has a much higher return on equity when compared to company A. Just looking at these numbers, we might conclude that it's great for a company to have debt. However, what are the disadvantages of debts? Well, interest on debt is a fixed cost. In bad times, when operating profit reduces, net income will drop dramatically.

Let's look at company A and B again, but now their operating profit has dropped from 100 to 35.

Company A, no interest. So it's profit before tax is 35. It pays some tax and it ends up with net income of 28. Much lower than before, but it still has some net income. Company B is very different. Company B's operating profit is initially the same as company A, but that's the only similarity because company B has debt, it still has that interest of 35 that's a fixed cost. They can't avoid it. So profit before tax is zero. Tax is zero, and net income unfortunately is zero.

So the return on equities have gone down. For company A, it's gone down to 2.8%, but still positive. Whereas company B's return on equity has dropped dramatically down to zero.

So what we see is that debt exaggerates return on equity down in bad times and up in good times. This means return on equity fluctuates more, and it means that investing in the company is more risky for investors.