There are two main methods for a corporation to raise capital to finance operations. Equity is the selling of parts of a company to investors. Investors buy several kinds of stock to take ownership and invest in the profitability of a corporation. The second method is to borrow money from creditors. One form of corporate loan is a bond. A bond differs from stock because it represents debt not equity in a firm. Creditors enjoy higher status that stockholders because companies have an obligation to make interest payments whereas dividends are a discretionary expenditure.
When companies take on debt, they are said to be leveraged. Financial leverage refers to the amount of debt a company has taken on to finance operations. Highly leveraged corporations are those that have taken on relatively high amounts of debt. Debt has both positive and negative effects on a corporation.
Since debt represents an obligation to creditors, the more debt a company takes on the more likely the company will default on a loan. Defaulting on a loan can lead to financial distress and eventually bankruptcy, especially if the firm is highly leveraged and is having trouble paying off multiple creditors. Even so, debt is a major source of funding.
One advantage of debt is that interest paid to creditors is tax-deductible just like any other expense. This is because interest is considered a cost of doing business. Unlike interest, dividends paid to stockholders are not tax-deductible so paying dividends is more expensive than paying interest. However, paying dividends sends signals to the market about the company’s profitability.
Debt represents how risk is borne by the stockholders. Debt financing increase the risk stockholders must bear reducing the price of stocks on a per-share basis. All things being equal, the highly leveraged firm’s stock price is lower than a firm with relatively low leverage.
Measuring debt as a financing option is one consideration when investing in stocks. Two common ratios are often used to evaluate a firm’s leverage and the risk taken on by investors. The debt ratio is simply the proportion of debt in comparison to the firm’s assets and is expressed as:
Debt ratio = Total Debt / Total Assets
Recall that the balance sheet identity is given as:
Assets = Liabilities + Owners’ Equity
Owners’ Equity = Assets – Liabilities
The total debt of a firm can be found on the balance sheet labeled as total liabilities and the assets of a firm are represented by total assets.
Suppose a firm’s balance sheet identity is given as:
$1,000,000 = $700,000 + $300,000
The Debt Ratio can be calculated as:
Debt Ratio = 300,000 / 1,000,000
Another useful calculation of leverage is called the debt/equity ratio. It indicates the total debt in comparison to total owners’ equity. The formula for the debt/equity ratio is given as:
Debt/Equity = Total Debt / Total Owners’ Equity
Using the balance sheet identity example above, the debt/equity ratio is calculated as:
Debt/Equity = 700,000 / 300,000
The choice to finance a company with either debt or equity has repercussions for both the corporation and its stockholders. Whereas interest paid on a loan is tax-deductible, debt increases the risk of stockholders which drives down the price of the stock. Commonly-used leverage ratios allow investors to compare both intra- and inter-company leverage so a clearer picture of the effects of leverage and the risk of owning a company’s stock can be seen.