How much of a company’s return really comes from debt?
Companies normally borrow money to finance expansion, acquisitions and other investments that can increase future earnings. By using debt instead of issuing new shares, a company can also increase return on equity (ROE).
This happens because debt allows a company to invest more capital without requiring shareholders to put in more money. If the borrowed funds generate enough profit to cover financing costs, the company can earn a higher ROE.
But borrowing can also work the other way. If the business does not generate enough return from those investments, debt can reduce rather than improve ROE.
So how can investors tell when borrowing helps improve ROE and when it starts to work against them?
In 2003, accounting professors Doron Nissim and Stephen Penman published a study in the Review of Accounting Studies that examined how financial leverage affects profitability. Instead of looking at ROE alone, they separated the return generated by a company’s operations from the effect of financing.
Their framework begins with return on net operating assets (RNOA). This measures after-tax operating profit relative to the net assets invested in the business.
Net operating assets are operating assets less operating liabilities. In this sense, they are similar to the capital invested in the operating business, separate from how it is financed.
The next measure is financial leverage, which reflects net financial obligations relative to shareholders’ equity. Net financial obligations take financial debt and subtract financial assets such as cash and other investments.
The framework then compares RNOA with the company’s net borrowing cost (NBC), which measures the after-tax cost of its net financial obligations. The difference between the two is called the leverage spread.
When RNOA is higher than the NBC, the spread is positive. This means the company earns a higher return from its operating assets than it pays for financing, which allows leverage to increase ROE.
But when RNOA falls below the NBC, the spread becomes negative. In this case, borrowing reduces ROE.
Nissim and Penman expressed this relationship through a simple equation as ROE = RNOA + Financial Leverage × (RNOA − NBC).
The equation shows that ROE can come from two sources: the return generated by the operating business and the additional return, or reduction in return, caused by financial leverage.
This means two companies can report the same ROE even though they arrive at it in very different ways. Take Meralco and PLDT.
In 2025, Meralco generated ROE of about 25.4 percent, while PLDT posted a similar return of 24.7 percent. But when their returns are broken down using our framework, Meralco generated an RNOA of about 20.8 percent and had financial leverage of only 0.33 times equity. Its positive leverage spread added about 4.6 percentage points to ROE.
PLDT, on the other hand, generated a much lower RNOA of about 9.5 percent, but had financial leverage of 2.75 times equity. The use of leverage added about 15.2 percentage points to its return, which brought its ROE to about the same level as Meralco.
This means that while Meralco and PLDT produced almost the same ROE, Meralco generated most of its return from its operating business, while a much larger portion of PLDT’s return came from financial leverage.
Now, if we apply this framework across the 26 companies in our sample, we find that leverage had a positive effect on ROE in 20 companies, or about 77 percent. The effect was particularly significant in PLDT, International Container Terminal Services Inc., ACEN, San Miguel, Globe and SM Prime, where leverage accounted for roughly one-third or more of ROE. Overall, leverage added an average of about 4 percentage points to ROE among these 20 companies.
But in five companies, the effect was negative. This did not necessarily mean that borrowing hurt returns. DigiPlus, Semirara and Monde Nissin, for example, had net financial asset positions, where financial assets exceeded financial obligations. Their lower dependence on debt meant that more of their returns came from the operating business itself.
For companies that rely more heavily on debt, however, the risk is different. If operating returns fall or borrowing costs rise, the positive spread can narrow and pull ROE lower. Debt can also make earnings more volatile because financing costs remain even when business performance weakens.
This higher financial risk can eventually affect valuation. Investors may be less willing to pay a high multiple for a company whose ROE depends heavily on leverage. A higher ROE may, therefore, look impressive, but the market may question whether that return can be sustained through periods of higher interest rates or weaker earnings.
This helps explain why two companies with the same ROE may not necessarily deserve the same valuation.
A company that generates strong returns mainly from its operating business may command a higher valuation because those returns are less exposed to financing risk.
Henry Ong is a registered financial planner of RFP Philippines. To learn more about investment planning, attend 118th batch of RFP Program this October 2026. To register, e-mail at [email protected].
