I talked this week about financial leverage during one of the college courses I’m teaching this semester. Financial leverage describes the use of debt financing as a means of levering earnings higher. Using debt financing is like using a crowbar on earnings. Indeed, when a company is experiencing profitability, it can enhance profits through the benefits of using debt to finance the assets used in operations.

How does financial leverage work? That is, how can borrowing money to finance a company’s operations lead to higher earnings? Well, to answer the question, we have to consider the sources of money available to companies to carry on business. Corporations raise capital (money) by either issuing (selling) stock or by borrowing. Selling stock generates equity capital while borrowing generates debt capital. Both forms of capital are shown on the company balance sheet; debt capital is shown within the Liabilities section while equity capital is shown within the Stockholders’ Equity section.

To understand financial leverage, we have to look at the costs of using debt capital versus using equity capital. It is easiest to understand financial leverage if we consider the cost of debt capital as “interest” and the cost of equity capital as “dividends.” As stated previously, the use of debt financing is the means of levering earnings higher. This is true because the interest cost on debt is less than the dividend cost on stock.

First, lenders take less risk than stockholders (lenders get satisfied before stockholders get anything in bankruptcy). So, lenders expect a lower return than stockholders. Second, lenders are paid a fixed amount of interest, no matter how much money the corporation makes off the financed assets. Stockholders will demand their share of ALL the profits attained. Third, interest cost is tax deductible to the corporation while dividends distributed are not tax deductible. Corporations have double taxation in that dividends are taxed to both the corporation and then again to the receiving shareholders. In sum, borrowing is cheaper to the corporation than issuing stock. This lowered cost can result in a higher bottom line (earnings) for the corporation that opts for debt financing over equity financing.

Stockholders love earnings which entices companies to employ debt financing liberally. This is especially true today while interest rates are at historical lows. However, there is a threat to shareholders of their company using too much debt. A company “must” make its interest and principal payments on schedule, each and every time or be faced with bankruptcy. On the other hand, a company never “has” to pay a dividend nor does it have to repay shareholders anything for their stock holding. Thus, the threat of bankruptcy increases with increased use of debt financing.

Many companies today hungry for more and more earnings per share (EPS) employ significant debt financing. While it can enhance profits, it can also destroy the company that gets too debt-happy and overextends itself. I preach balance sheet analysis for ascertaining the risk involved with a common stock investment. Only the balance sheet reflects the extent to which debt is adversely impacting the health of the balance sheet and putting investors at heightened risk.