Financial Leverage
1. List and explain the advantages of debt financing.
2. List and explain the disadvantages of debt financing.
3. Explain and illustrate the use of financial leverage.
4. Define “notes” and “bonds” as used in debt financing.
Question: Businesses and other organizations need funds to finance their operations and possible expansions.
Such amounts can be quite significant. A portion of this money is normally contributed by investors who choose to
become owners through the purchase of shares of capital stock. Cash can also be generated internally by means of
profitable operations. If net income exceeds the amount of dividends paid each period, a company has an ongoing
source of financing.
However, many companies obtain a large part of the funding needed to support themselves and their growth
through borrowing. If those debts will not be paid back within the following year, they are listed on the balance
sheet as noncurrent liabilities. Target Corporation, for example, disclosed in its financial statements that it owed
$19.9 billion in noncurrent liabilities as of January 31, 2009.
Incurring debts of such large amounts must pose some risks
to an organization. Creditors expect to be repaid their entire loan balance plus interest at the specified due date.
What problems and potential dangers does an entity face when liabilities—especially those of significant size—are
owed?
Answer: Few things in life are free so the obvious problem with financing through debt is that it has a cost. A bank
or other creditor will charge interest for the use of its money. As an example, Target Corporation reported interest
expense for the year ending January 31, 2009, of approximately $900 million. The rate of interest will vary based
on economic conditions and the financial health of the debtor. As should be expected, strong companies are able
to borrow at a lower rate than weaker ones.
In addition, a business must be able to generate enough surplus cash to satisfy its creditors as debts come due.
As indicated, Target reports noncurrent liabilities of $19.9 billion. Eventually, company officials have to find
sufficient money to satisfy these obligations. Those funds might well be generated by profitable operations or
contributed by investors. Or Target might simply borrow more money to pay off these debts as they mature.