Question

Critique this statement: “The use of debt financing lowers the net income of the firm, and hence debt financing should be used only as a last resort.”

Answer 1

“The use of debt financing lowers the net income of the firm, and hence debt financing should be used only as a last resort.”

This statement is correct at its face value. The use of debt financing will lower net income, as net income = operating income (EBIT) - interest - taxes.

The use of debt in the capital structure increases the firms' financial leverage. Financial leverage is the use of debt in the capital structure. Degree of financial leverage is measured as % change in net income / % change in EBIT. The higher a firm's financial leverage, the more risky its capital structure due to the use of debt. Debt has an obligation of periodic interest payments and this puts pressure on the cash flows

However, there is another aspect to it. The use of debt can increase the earnings per share (EPS) of the firm. With the use of debt, although the net income may be lowered, the earnings per share of equity shareholders will increase. This is the benefit of using debt in the capital structure. Hence a more appropriate measure of degree of financial leverage is % change in EPS divided by % change in EBIT