The Pros and Cons of Higher Debt/Equity Ratios

Introduction

You're weighing a higher debt/equity ratio (D/E) to fund growth or buybacks, and the decision really comes down to two things: how stable your cash flows are and what the cost of debt will be. D/E = total debt ÷ shareholders equity - plain English: how much of the company is financed by lenders versus owners; for example, if total debt is $500,000,000 and shareholders equity is $1,000,000,000, D/E = 0.5, meaning lenders finance half of the owners' stake. If your cash covers interest easily (think interest coverage north of 3x) and rates stay low, higher leverage can boost returns on equity, but if cash slips or rates jump, your default and flexibility risk rises - higher leverage can raise returns but also raises default and flexibility risk. If costs climb or cash weakens, your plan will defintely feel the squeeze.

Key Takeaways

• Higher D/E can amplify ROE but increases default and flexibility risk-decision hinges on cash-flow stability and cost of debt.
• Interest tax shield lowers after‑tax debt cost (e.g., 6% × (1-21%) = 4.74%), so incremental debt helps only if return on assets > after‑tax debt cost.
• Use clear metrics: debt/EBITDA targets (<3x for investment grade; 3-5x for higher risk) and interest coverage >3x; stress‑test for rate shocks and revenue declines.
• Execution safeguards: stagger maturities, hedge rate exposure, monitor covenants, and maintain a 12-24 month liquidity runway.
• Raise leverage only when incremental return > after‑tax debt cost and covenants/liquidity stay healthy; run three FY2025 scenarios (base, +2% rates, -20% revenue) at current, +25%, +50% D/E.

Tax shield and lower WACC

You're weighing higher debt/equity to fund growth or buybacks; the quick takeaway: debt lowers your effective financing cost through a tax shield, but only if the incremental cost of debt stays below the returns you generate. Act on clear math, not gut feelings.

Interest is tax-deductible and the federal rate matters

If you pay interest on debt, that interest reduces taxable income and therefore your tax bill. With the US federal corporate rate at 21%, the basic tax shield is meaningful for most corporates in FY2025.

Practical steps and checks:

• Quantify the shield: multiply expected interest expense by 21% to get annual cash tax saved.
• Confirm limits: check for interest deductibility limits (Section 163(j) effects), state taxes, and any available net operating loss (NOL) carryforwards that change the effective shield.
• Model net cash impact: include upfront fees, amortization, and deferred tax timing in year-by-year cash flows for FY2025.
• Get tax counsel sign-off when incremental debt exceeds material thresholds (>$50m or when changing capital structure meaningfully).

One-liner: the tax shield cuts your cash tax bill, but verify legal limits and state taxes, defintely.

Higher debt can reduce WACC if incremental debt cost is lower than asset returns

WACC (weighted average cost of capital) falls when cheaper debt replaces expensive equity and the after-tax cost of debt stays below your asset returns. Use the WACC formula: WACC = (E/V)Re + (D/V)Rd(1 - Tc).

Practical guidance:

• Compute marginal Rd for FY2025: include coupon, issuance costs, and covenant premium.
• Estimate Re (cost of equity) using a recent market-implied approach (CAPM or implied ER); refresh parameters for 2025 market volatility.
• Run a WACC sensitivity table: vary Rd ± 50 bps and D/V from current to target and record valuation delta.
• Set a policy trigger: increase leverage only when incremental ROA > after-tax Rd by a comfortable spread (recommend at least 150-200 bps cushion).

One-liner: reduce WACC only when the math-marginal Rd vs ROA-clearly favors debt.

Quick math example and how to use it in decision-making

Example for FY2025: if debt costs 6% and the corporate tax rate is 21%, the after-tax cost of that debt is 4.74% (6% × (1 - 0.21)).

Apply the example to a capital structure move:

• Start: all-equity cost Re = 10%.
• Action: borrow $50m against $100m equity (D/E = 0.5; total value V = $150m).
• Weights: E/V = 66.7%, D/V = 33.3%.
• WACC = 0.66710% + 0.3334.74% = 8.25%; that's a drop from 10% to 8.25%, lifting valuation all else equal.

What this estimate hides: rising leverage can push marginal Rd above 6%, increase equity beta (cost of equity), and introduce covenant or refinancing premia; always run a stressed scenario.

Actionable next step: Finance - run three FY2025 scenarios (base, +2% interest rate shock, -20% revenue) with D/E at current, +25%, +50% by Friday; owner: Head of Finance.

Return on equity amplification and shareholder returns

You're weighing higher leverage to boost shareholder returns; you need to know when debt truly amplifies ROE and when it just magnifies risk.

Below I walk through the mechanism, a concrete worked example with FY2025-style numbers, and pragmatic controls you should put in place.

How leverage magnifies returns

Leverage increases ROE when the company's return on assets (ROA) exceeds the after‑tax cost of debt. In plain terms: if every dollar of assets earns more than the lender charges, owners see a bigger slice of profit per dollar of equity.

One-liner: leverage amplifies gains when ROA > after-tax debt cost, and amplifies losses when it isn't.

Practical steps and checks you should run before adding debt:

• Compute incremental ROA on the intended use (M&A, capex, buybacks).
• Compare to after-tax debt cost: cost × (1 - 21% federal tax).
• Require a margin: target ROA > after-tax cost by at least 200-300 bps.
• Model at least three scenarios: base, downside (-20% revenue), upside.
• Include issuance fees, covenant drag, and one-time charges in your hurdle.

What this hides: ROA can be lumpy or project-specific; don't assume corporate-average ROA applies to new investments.

Concrete worked example

Scenario: your firm has $100m of equity, borrows $50m at interest 6%, and the business generates ROA of 9%. Here's the quick math using FY2025 tax assumptions (21% federal):

• Assets after borrowing = $150m.
• Operating income (ROA × assets) = $13.5m (9% × $150m).
• Interest = $3.0m (6% × $50m).
• Pretax income = $10.5m.
• Net income = $8.295m (after 21% tax).
• ROE = net income / equity = 8.30% (≈8.3%).

Baseline without debt (assets = $100m): operating income = $9.0m, net income = $7.11m, ROE = 7.11%. So leverage raised ROE from 7.11% to 8.30%.

Flip side quick example: if ROA falls to 4%, operating income = $6.0m, interest still $3.0m, net income ≈ $2.37m, ROE ≈ 2.37% - lower than the unlevered ROE of 3.16%. Small ROA shifts matter a lot.

Limits: this ignores covenant costs, incremental working capital needs, and possible higher spreads on new debt in stressed markets - so defintely model those.

Managing the increased volatility and downside

Higher ROE potential comes with bigger swings in earnings and equity value. Your job: capture upside while limiting ruin risk.

Concrete controls and execution steps:

• Stress-test: run -20% revenue and +200-300 bps rate shocks for 12-24 months.
• Set hard covenants: maintain interest coverage > 3x and debt/EBITDA targets (<3x for investment-grade profile).
• Stagger maturities: avoid >20-30% of principal coming due in any 12‑month window.
• Hold liquidity: keep a rolling 12-24 month cash runway (cash + revolver capacity).
• Hedge selectively: fix rates on long-term debt or use swaps for planned capex; cap variable exposure on buybacks.
• Trigger plan: define automatic deleveraging actions (asset sales, halt buybacks) once coverage or liquidity thresholds hit.

Owner and next steps you can use right now: have Finance run a sensitivity matrix showing ROE, interest coverage, and covenant headroom across the three scenarios from your model; use that to set the incremental ROA hurdle and the automatic deleveraging triggers.

Operational and financial risks of higher leverage

Interest coverage falls as debt rises - aim for a cushion

Takeaway: as you add debt, EBIT divided by interest (interest coverage) drops quickly; target a cushion above 3x to survive shocks.

Here's the quick math using a FY2025 example you can run today: if FY2025 EBIT = $120m and existing interest = $15m, coverage = 8.0x (120/15). Add new debt that costs 6% and generates $12m incremental interest, total interest = $27m, coverage falls to 4.44x.

What this hides: a 20% drop in EBIT (down to $96m) pushes coverage to 3.56x. A 200-300 bps rate shock raises interest further and can breach covenant floors quickly.

Practical steps

• Model monthly coverage, base and stressed scenarios
• Set internal trigger at 1.5x above covenant
• Require (and test) 12-24 month liquidity runway
• Fix part of debt to reduce cash-flow volatility

Owner and next step: Finance - run a monthly interest-coverage waterfall for FY2025 stress (base, -20% EBIT, +300 bps rate) by Friday; owner: Head of Finance.

Higher D/E raises bankruptcy probability and refinancing risk

Takeaway: more leverage increases default likelihood and makes rollovers expensive or impossible when rates spike; refinance risk is the dominant mid-term hazard.

Concrete example: a company with $500m debt at 6% pays $30m interest. A jump to 9% (a 300 bps shock) raises interest to $45m - an incremental $15m hit to EBITDA. If debt/EBITDA moves from 3.5x to >4.5x, rating actions and covenant breaches become likely.

Best practices

• Stagger maturities to avoid 30-40% short-term puts
• Lock long-term fixed rates when term premium is reasonable
• Keep committed revolver unused as dry powder
• Model refinancing under +200-300 bps scenarios

Owner and next step: Treasury - map maturities and simulate rollover at +200/300 bps for FY2025; produce a mitigation plan (extend, hedge, or prepay) by Wednesday; owner: Treasurer.

Covenants and liquidity constraints tighten, reducing flexibility

Takeaway: lenders impose tests (leverage, interest coverage, restricted payments) that limit dividends, M&A, and capex when leverage rises.

Common covenant mechanics: maintenance tests (Debt/EBITDA < 4.0x), interest coverage floors (> 3.0x), and cash traps that block distributions once triggers hit. These clauses shift optional expenditures into discretionary decisions.

Practical, actionable guidance

• Negotiate covenant baskets and step-downs up front
• Run covenant roll-forwards monthly and flag breaches
• Maintain a committed 12-24 month liquidity buffer
• Define clear decision rights for covenant stress

Example operational rule: if covenants tighten, pause buybacks and reallocate cash to liquidity until coverage > 3.5x.

Owner and next step: Legal & Finance - extract all FY2025 covenant definitions and create a single covenant dashboard; update board weekly; owner: Head of Finance. Also defintely model downside covenant outcomes.

Market and macro considerations in 2025

Capital markets show tighter spreads vs pre-2022 but rate uncertainty remains; lock long-term rates when possible

You're deciding whether to increase leverage while markets still offer relatively tighter credit spreads compared with the shock period around 2020-2022 - so the temptation to borrow is real, but rate volatility is still elevated.

One-liner: if you need certainty on interest expense, lock long-term rates; if you can absorb volatility, prefer cheaper floating exposure.

Practical steps:

• Issue fixed-rate debt to lock coupon for the full funding horizon.
• Use interest-rate swaps to convert floating to fixed when bond issuance is expensive.
• Buy rate caps for partial protection if you want upside from rate falls.
• Target hedges to cover the next 12-36 months of interest payments when refinancing risk is material.

Quick math: saving 50 bps on a $100m facility equals $500k annual interest saved - so compare hedge cost to that run-rate. What this hides: prepayment, covenant changes, and basis between swap and bond markets can shift the economics, so get quotes from multiple banks before committing.

Lenders favor lower leverage for cyclical sectors; apply sector-specific D/E benchmarks

You should match target leverage to how stable cash flows are for your sector - lenders are still more conservative on cyclical firms in 2025, and they'll price covenants and spreads accordingly.

One-liner: sector risk drives acceptable D/E more than a single corporate target.

Benchmark guidance (use as starting points, adjust for cash stability):

• Tech and high-growth SaaS: target D/E 0.0-0.8x, prefer cash-rich balance sheets.
• Consumer staples and healthcare: target D/E 0.5-1.5x, tolerate moderate leverage with steady EBITDA.
• Industrials and cyclical manufacturing: target D/E 0.5-1.5x, but tighten when order book is weak.
• Utilities and telecom: target D/E 1.5-3.5x, long-lived assets support higher leverage.

Execution checklist:

• Run a covenant sensitivity table for EBITDA swings of -10%, -20%, -30%.
• Benchmark recent sector deals for spreads and covenant language; target at-par or better terms where possible.
• Discuss with lenders early; get term sheets that include waiver mechanics for cyclical dips.

Match leverage to macro cycle and refinance windows, not just target ROE

You need to time leverage with your refinance windows and the macro cycle - raising D/E near a refinancing trough reduces roll risk and keeps covenants sane.

One-liner: match leverage to macro cycle and refinance windows, not just target ROE.

Concrete actions:

• Map maturities over a 5-year horizon and avoid >30% of debt maturing in any 12-month window.
• Stress test a 200-300 bps upward rate shock on interest expense and coverage ratios.
• Maintain a rolling liquidity runway of 12-24 months (cash + undrawn facilities) before increasing D/E.
• Stagger maturities and use a mix of bank facilities, bonds, and private debt to diversify refinancing channels.

Best practice: before changing capital structure, require finance to model three FY2025 scenarios (base, +200 bps, -20% revenue) and show covenant headroom and liquidity to confirm you can survive the adverse case - defintely get that signed off by the treasury lead.

Practical rules, metrics, and execution steps

Use debt/EBITDA targets and adjust for cash flow stability

You're weighing how much leverage to add this fiscal year; here's the direct takeaway: target debt/EBITDA under 3x for an investment-grade profile, and treat debt/EBITDA of 3-5x as higher-risk only with stable cash flow and covenant headroom.

Start with a clear base case using trailing and pro-forma figures: compute trailing 12-month EBITDA, add back one-offs, and project FY2025 EBITDA under base and downside scenarios. Example quick math: if FY2025 EBITDA = $120m and total debt = $300m, debt/EBITDA = 2.5x - within the investment-grade target.

Practical steps:

• Calculate trailing 12-month and FY2025 pro‑forma EBITDA
• Include recurring adj. and remove one-offs
• Set soft limit at 3x for IG capital
• Raise limit to 3-5x only with stable cash flow
• Document scenarios that push EBITDA below covenant levels

One clean line: keep leverage where covenants and cash can handle a cycle downturn - defintely model downside.

Monitor covenant tests, short-term maturities, and stress scenarios

Direct takeaway: track covenant headroom monthly and stress test for a 200-300 bps rate shock plus a revenue decline scenario; if headroom vanishes, don't add debt.

Run a covenant dashboard that includes current ratios, next 24-month covenant tests, and triggers (e.g., max debt/EBITDA). For each loan and bond, list the covenant metric, current value, covenant threshold, and next test date. Flag any covenant within 0.25x or 30 days of testing as high priority.

Stress-test templates to run weekly:

• Base, +200 bps, +300 bps
• Revenue shock: -20% and -40%
• Combined rate + revenue stress
• Rolling 12‑month liquidity under each stress
• Refinance window and covenant breach outputs

One clean line: if a 200-300 bps move breaks coverage, stop at that lever point and fix maturities before drawing new debt.

Hedge interest-rate exposure, stagger maturities, and require a liquidity runway

Direct takeaway: cap floating-rate exposure, stagger maturities across >12-24 months, and hold committed liquidity to cover operating needs under stress.

Execution checklist:

• Cap floating exposure to a max percentage
• Use swaps to convert floating to fixed
• Stagger maturities across 3-7 tranches
• Secure committed revolver capacity for 12-24 months
• Maintain cash + undrawn lines = operating burn × 12 months (minimum)

Worked example: $300m floating debt facing a 200 bps rise adds roughly $6m in annual interest (0.02 × $300m) - hedge or fix that exposure if this change meaningfully reduces interest coverage below 3x.

One clean line: hedge the shock you would not accept, stagger maturities, and require a rolling 12-24 month liquidity runway.

Action: Finance - run three FY2025 scenarios (base, +2% rate, -20% revenue) with current, +25%, and +50% D/E by Friday; owner: Head of Finance.

The decision to raise leverage and the execution plan

When to raise leverage

You're weighing more debt to fund growth or buybacks; decide only when the incremental return exceeds the after‑tax cost of the debt, covenants remain healthy, and you can survive at least 12-24 months of stress.

Here's the quick math to check the core test: if new debt costs 6% and the US federal tax rate is 21%, after‑tax debt cost = 4.74% (6% × (1 - 21%)).

Example: you have $100m equity, borrow $50m at 6%, and ROA (return on assets) is 9%. Assets = $150m, EBIT = $13.5m, interest = $3m, EBT = $10.5m, tax = $2.205m, net income = $8.295m, ROE ≈ 8.30% vs no‑debt ROE ≈ 7.11%. That uplift matters - but it swings the other way if ROA < cost of debt.

One‑liner: raise leverage only when incremental return > after‑tax debt cost and liquidity plus covenants pass stress tests.

Safeguards, covenants, and liquidity rules

Before you pull the trigger, lock a checklist that protects cash flow and optionality: monitor covenant headroom, interest coverage, maturities, and short‑term liquidity.

• Target interest coverage > 3x for margin of safety
• Keep debt/EBITDA <3x for investment‑grade profile
• Plan rolling liquidity for 12-24 months
• Stress rates by 200-300 bps and revenue by -20%
• Stagger maturities; avoid >30% of debt maturing in any 12 months

Practical steps: obtain covenant matrices from lenders, run sensitivity on covenant triggers, build a 13‑week cash model, and get legal to pre‑clear waiver language. Hedge floating exposure where the NPV of hedges < cost of potential coverage loss. Also defintely model downside - lack of runway is the fastest path to forced deleveraging.

One‑liner: protect runway and covenant headroom before adding leverage.

Immediate action items - FY2025 scenario runs and deliverables

Finance must run three consolidated FY2025 scenarios with D/E at current, at +25%, and at +50%, using these parameters: base rates (assume current coupon for existing debt), a rate shock of +2% (an incremental +200 bps to new/variable debt), and a downside revenue case of -20%.

• Model outputs: P&L, cash flow, balance sheet
• Stress tests: covenant ratios, interest coverage, debt/EBITDA
• Liquidity: 13‑week cash, committed facilities, unencumbered cash
• Refinancing plan: maturities, callable amounts, market access
• Valuation impact: WACC and DCF delta vs base
• Mitigants: hedging cost, facility amendment needs, contingency draws

Roles: FP&A - build the scenarios and sensitivity tables; Treasury - run refinancing and hedging cost estimates; Legal - map covenant language and waiver options; CFO - review assumptions and sign off.

Deliverable and deadline: consolidated deck plus a 13‑week cash view, due by Friday; owner: Head of Finance.

One‑liner: run the three FY2025 scenarios now, show covenant headroom, and give a clear yes/no to incremental leverage.