“Every time you borrow money, you’re robbing your future self.” – Nathan W. Morris
Of course, since capital is one of the basic requirements of production, companies – especially those with a dearth of resources – often resort to debt financing to boost up their future earnings. This is because equity financing is relatively costlier. Another perk to debt financing is that the interest expense is tax deductible.
However, for a safe investment strategy, understanding the amount of financial leverage that a company bears is crucial. This is because financial leverage multiplies the underlying business risk. So, while financial leverage brings with it the expectation of increased return in the future, it also carries the risk of losing money substantially. In fact, in any unfavorable turn of events, exorbitant debt financing bears the risk of dragging a company into bankruptcy.
For the purpose of safe investment in stocks, varied parameters based on leverage ratio have been constructed historically. These parameters serve the purpose of estimating the credit worthiness of a company. One such prominent tool is debt-to-equity ratio.