Corporate Finance Fundamentals: Financial Leverage, Capital Structure, and Solvency

Why Leverage Matters: Amplifying Outcomes

Financial leverage means using borrowed money (debt) to finance assets and operations. Leverage can increase the return earned by shareholders when the business performs well, but it also increases the downside when performance weakens because debt creates fixed contractual payments (interest and principal).

Mechanics: How Debt Can Boost Equity Returns

Debt holders typically receive a fixed return (interest). Equity holders receive the residual: what is left after paying operating costs and interest. When a company adds debt, it can sometimes generate more earnings on the same equity base, raising return on equity (ROE), as long as operating profits comfortably exceed interest costs.

Simple intuition: If the company earns a higher return on the borrowed funds than the interest rate it pays, the excess accrues to equity holders. If it earns less, equity holders absorb the shortfall.

Mechanics: How Debt Can Magnify Losses

When operating profit falls, interest expense does not automatically fall. That means a smaller cushion for equity and a higher probability of distress. In severe cases, inability to meet payments can trigger covenant breaches, refinancing stress, asset sales at unfavorable prices, or bankruptcy.

• Upside: Potentially higher ROE and faster growth without issuing new shares.
• Downside: Higher fixed obligations, higher volatility of equity returns, reduced flexibility, and higher bankruptcy likelihood.

Capital Structure Choices: Risk, Flexibility, and Bankruptcy Likelihood

Capital structure is the mix of debt and equity used to finance the business. Choosing that mix is a balancing act between expected returns and resilience.

Continue in our app.

• Listen to the audio with the screen off.
• Earn a certificate upon completion.
• Over 5000 courses for you to explore!

Or continue reading below...

Download the app

How More Debt Changes the Business

• Risk to equity increases: Equity becomes a smaller “cushion” under the asset base, so changes in operating performance have a larger percentage impact on equity value.
• Financial flexibility decreases: High leverage can limit the ability to borrow later for opportunities or to survive downturns.
• Bankruptcy likelihood increases: More required payments and tighter covenants raise the chance of distress in a bad year.
• Potential discipline effect: Required payments can push management to allocate cash more carefully, but only if leverage is sustainable.

What Drives a Sensible Capital Structure (Context Matters)

• Business stability: Predictable, recurring cash flows can support more debt than volatile cash flows.
• Asset type: Assets that can serve as collateral (property, equipment) often support higher borrowing capacity than intangible-heavy businesses.
• Industry norms: Lenders and investors compare leverage to peers; “high” in one industry may be “normal” in another.
• Growth needs: Fast-growing firms may prefer flexibility (more equity) to avoid being constrained by debt service.
• Interest rate environment and refinancing risk: Short-term or floating-rate debt can become expensive quickly.

Core Solvency and Coverage Ratios (and How to Interpret Them)

Solvency focuses on the ability to meet long-term obligations and remain financially viable. The ratios below help quantify leverage and the ability to service debt.

1) Debt-to-Equity (D/E)

Formula:

Debt-to-Equity = Total Debt / Total Equity

Interpretation: Higher D/E generally means more leverage and higher financial risk. But interpretation depends on industry and accounting (e.g., share buybacks can reduce equity and mechanically increase D/E).

• Use it when: Comparing capital structure across companies or tracking leverage over time.
• Watch out for: Very low equity (or negative equity) can make D/E misleading.

2) Debt-to-Assets (Leverage Ratio)

Formula:

Debt-to-Assets = Total Debt / Total Assets

Interpretation: Shows what fraction of assets is financed by debt. A higher ratio implies a thinner equity cushion.

3) Interest Coverage (Times Interest Earned)

Formula:

Interest Coverage = EBIT / Interest Expense

Interpretation: Measures how many times operating profit (EBIT) covers interest. Higher is safer. Low coverage indicates vulnerability to earnings declines or rate increases.

• Rule-of-thumb thinking (not universal): Coverage below ~2x often signals elevated risk; 3–5x may be comfortable for many stable businesses; highly cyclical businesses often need more cushion.
• Context checks: If EBIT is volatile, a “good” coverage in a strong year may not be enough.

4) Debt Service Coverage Ratio (DSCR) (when principal matters)

Lenders often care about total debt service (interest + required principal payments).

Common simplified form:

DSCR = EBITDA / (Interest + Required Principal Payments)

Interpretation: A DSCR above 1.0 means the company generates enough operating cash earnings to cover required debt service; higher provides more buffer.

Note: DSCR definitions vary by lender and may adjust for taxes, maintenance capex, or working capital needs.

Putting Ratios in Context: A Practical Checklist

• Compare to peers: Use industry norms to avoid labeling a capital-intensive utility as “overleveraged” using a software-company benchmark.
• Look at stability: A stable subscription business can carry more leverage than a commodity producer with volatile margins.
• Check trend: Rising leverage and falling coverage over time is often more concerning than a single-year snapshot.
• Stress test: Ask: “What happens to coverage if EBIT drops 20% or interest rates rise 200 bps?”

Structured Comparison: Two Companies, Two Leverage Profiles

Below are two simplified companies with the same operating profit (EBIT) but different financing choices. This isolates the effect of leverage on risk and shareholder outcomes.

Step 1: Compute Key Ratios

Debt-to-Equity:

• Company A: 200 / 800 = 0.25
• Company B: 700 / 300 = 2.33

Debt-to-Assets:

• Company A: 200 / 1,000 = 0.20
• Company B: 700 / 1,000 = 0.70

Interest Coverage (EBIT/Interest):

• Company A: 120 / 12 = 10.0x
• Company B: 120 / 42 = 2.86x

Step 2: Translate Ratios into Risk and Flexibility

• Company A (Low Leverage): Very strong interest coverage and a large equity cushion. It likely has more flexibility to borrow later, withstand downturns, or invest through a recession.
• Company B (High Leverage): Much thinner cushion and materially lower coverage. It may deliver higher ROE in good times (because equity is smaller), but it is more exposed to earnings declines, covenant pressure, and refinancing risk.

Step 3: Show How a Downturn Changes the Picture

Assume EBIT falls by 40% (from $120 to $72) due to a demand shock.

• Company A coverage: 72 / 12 = 6.0x (still comfortable)
• Company B coverage: 72 / 42 = 1.71x (now tight; a further decline or rate increase could push coverage near 1.0x)

This illustrates why high leverage increases bankruptcy likelihood: the fixed interest burden consumes a larger share of operating profit when conditions deteriorate.

Step 4: Trade-Off Summary (Decision Lens)

Practice Segment: Compute Ratios and Make a Financing Recommendation

Use the simplified financial statements below to compute solvency and coverage ratios, then translate the results into a recommendation.

Practice Data: Simplified Statements (Company C)

Additional info for DSCR practice: Required principal payments next year = $60.

Task A: Compute the Ratios (Step-by-Step)

1) Debt-to-Equity

D/E = Total Debt / Total Equity = 800 / 400 = 2.0

2) Debt-to-Assets

Debt-to-Assets = Total Debt / Total Assets = 800 / 1200 = 0.667

3) Interest Coverage

Interest Coverage = EBIT / Interest = 150 / 50 = 3.0x

4) DSCR (using EBITDA)

First compute EBITDA:

EBITDA = EBIT + D&A = 150 + 30 = 180

Then DSCR:

DSCR = EBITDA / (Interest + Principal) = 180 / (50 + 60) = 180 / 110 = 1.64x

Task B: Interpret the Results in Context

• D/E = 2.0 and Debt-to-Assets = 0.667 indicate a debt-heavy structure with a relatively thin equity cushion.
• Interest coverage = 3.0x suggests the company can pay interest from operating profit, but the cushion is not large if earnings are volatile or rates rise.
• DSCR = 1.64x indicates the company can cover interest plus required principal payments, but a downturn could quickly compress this buffer.

Task C: Translate Ratios into a Financing Recommendation

Make a recommendation by linking the ratios to risk tolerance and business stability. Use the framework below.

Recommendation Framework (Fill-In)

• If the business is stable (recurring revenue, low cyclicality): The current leverage may be acceptable, but prioritize extending maturities, maintaining liquidity reserves, and avoiding additional debt unless it clearly improves cash generation or replaces more expensive debt.
• If the business is cyclical or margins are volatile: The leverage profile is aggressive. Consider deleveraging (retain earnings, reduce discretionary spending, sell non-core assets) or refinancing to reduce near-term principal burden. Avoid taking on new debt for expansion until coverage improves.
• If planning a new borrowing round: Stress test EBIT (e.g., -20% and -40%) and recompute coverage and DSCR. If interest coverage would fall near ~2x or DSCR near ~1.2x under a realistic downside case, prefer equity or a smaller project scope.

Optional Extension: Quick Stress Test (Do It Yourself)

Assume EBIT drops 25% next year (from $150 to $112.5) while interest and principal stay the same. Compute:

• New interest coverage = 112.5 / 50
• New EBITDA = 112.5 + 30
• New DSCR = EBITDA / 110

Then decide whether Company C should (1) take on more debt, (2) refinance/extend maturities, or (3) reduce leverage before expanding.