Question

When a firm uses more debt , the greater the financial leverage , which magnifies both risk and return . what does this statement mean ? Does this apply to your personal finances and how much personal debt, is too much debt?

Answer 1

Taking on more debt increases a firm's capacity to finance new business ventures, projects and increases the business in scale and volume. Increased business implies more revenues and hence, higher returns.

However, higher level of debt also implies higher levels of risk in terms of higher credit risk and default risk for the firm. High debt implies high interest cost. If the firm is going through a bad business cycle due to tough economic conditions, then banks and other lenders will push for the debt repayment. This affects the decision making of senior management of the firm. Firm is not able to take decisions without the consent of lenders in many cases and ultimately the firm might even default on the interest payments if the debt level becomes too high. Then the lenders will push the firm to file bankruptcy.

There is always an optimum level of debt beyond which the interest costs become too high and also the high level of stress because of high debt levels makes the higher debt levels unviable. This rule applies to corporate finance and to personal finance too. For a person, the optimum levels of debt are those in which he is able to repay the monthly debt payment conveniently from his monthly income.