Companies frequently use debt to finance their operations. This so-called leverage can be a prudent use of capital, but it can also be rather dangerous.
That’s because, once on the books, debt represents a fixed cost in the form of interest payments that cannot be easily adjusted. That means when sales decline, the impact of interest expense is magnified.
There is another kind of leverage too: Operational leverage. Companies with high fixed costs, such as property and equipment, can reduce the cost per unit by producing more units. That’s operating leverage in a nutshell. However, if conditions change, operationally-leveraged companies have fewer choices to manage expenses, while those with a variable cost structure can adapt quickly to prevailing conditions.
What kinds of companies have high fixed costs? Think of manufacturers like Boeing (NYSE: BA) and Ford (NYSE: F), who make huge investments in capital equipment to bend metal, weld parts, and warehouse inventory. Whether Boeing makes one plane or 1,000, those costs don’t change.
The risk of operational leverage is compounded when executive leadership takes on huge levels of debt, and Boeing and Ford happen to be among the most levered companies in the United States, according to an analysis by Investor’s Business Daily. Boeing’s total debt is a whopping 58 times its flow. Ford’s is 18 times its flow. While interest is a fraction of the total debt, the interest expense gets bigger and bigger as a percentage of cash flow when sales and profits sink. In truly dire circumstances, interest can eclipse cash flow and, if that happens, nothing good follows.