How do we finance our business?
Financial leverage is appropriate when it is likely that a company will be able to meet its principal and interest requirements. A company with stable profits and cash flows usually is in a better position to use a large amount of financial leverage than a company with volatile profits and cash flows. Companies with predictable revenues and expenses often use a lot of financial leverage. Examples include regulated utilities that can predict revenues, based on approved rate charges, and expenses based on well defined customer groups and demand. Many manufacturing companies also have stable demand for mature products. Expenses are relatively stable because they are linked to stable sales and production processes. Companies with large amounts of plant assets also are able to borrow large amounts of money because their physical assets can be used as collateral for the loans. Capital structure is the way a company chooses to finance its assets and operating activities. A corporation’s capital structure includes common stock and retained earnings. In addition, it may include preferred stock, long-term debt, and short-term obligations. Capital structures differ because the transformation processes of companies differ. Some companies require large investments in plant assets. They may borrow to finance these investments. Capital structures also differ because the financial performances of companies vary. Highly profitable companies often accumulate large proportions of retained earnings. If they are able to generate net cash inflows from their operating activities, they may have little need to borrow money. Companies that cannot generate sufficient cash flows from operating activities often issue long-term debt and preferred stock. Companies with stable revenues and earnings often can support relatively more debt in their