A Company’s Limit of Indebtedness (Draft)

Abstract

Contracting debt carriers two effects. Debt affects the return on equity ratio. Such effect is known as financial leverage. The second result is connected with a risk of losing continuity of operation due to problems with repayment of incurred credits and loans. This other result is a subject of constant debate in the economic literature. Nevertheless, in spite of an immense intellectual effort, the science still cannot provide precise instructions on what level of indebtedness is the best for a particular company. We have no exact answers as to what proportion between debt and capital and reserves is optimal. Still, the practice proves that different levels of indebtedness result in different consequences. In this paper I try to answer a couple of issues. How then do we decide about the ways of controlling the level of debt? At what level of indebtedness can we be sure that there is a danger to continuity of company’s operation? How, using simple tools, can we assess the influence of indebtedness upon the possibility of losing continuity? What factors should we take into account when deciding about incurring debt?

Keywords: Financial Leverage, Indebtedness, ROA

JEL Classification: G32