Advantage of Debt Financing

Another advantage associated with debt financing is that it can be eliminated. Liabilities are not permanent. If the

economic situation changes, a company can rid itself of all debt simply by making payments as balances come

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due. In contrast, if money is raised by issuing capital stock, the new shareholders can maintain their ownership


However, the biggest advantage commonly linked to debt is the benefit provided by financial leverage. This term

refers to an organization’s ability to increase reported net income by earning more money on borrowed funds than

the associated cost of interest. For example, if a company borrows $1 million on a debt that charges interest of 5

percent per year, annual interest is $50,000. If the $1 million can then be used to generate a profit of $80,000, net

income has gone up $30,000 ($80,000 – $50,000) using funds provided solely by creditors. The owners did not

have to contribute any additional funds to increase profits by $30,000.

Over the decades, many companies have adopted a strategy of being highly leveraged, meaning that most of their

funds came from debt financing. If profitable, the owners can make huge profits with little investment of their

own. Unfortunately, companies that take this approach have a much greater risk of falling into bankruptcy because

of the high volume of debts that have to be serviced.