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
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.