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viii.            Net Income

Net Income represents what is loosely called “the bottom line” by the layman on the street. It represents the amount of money going directly to the shareholders or to the reserves of the company (in order to be reinvested during the next fiscal year). Net income is sensitive to the financial structure of the company, and the more debt, the lower the net income for a given period, but the higher the tax savings resulting from the payments of interests, since interests on debt are deductible from taxable income. The following example will illustrate this fact better.

Example: leveraged lollipops company

A company is said to be highly leveraged when the ratio Net Debt / Shareholder’s equity (called financial leverage) is very high (typically >1).

Assume company A is producing lollipops, and is financed only with equity (no debt outstanding). We know that its net income will be X for the period.

Now compare A with company B which is 50% financed by debt (with face value D), and who is paying i*D interests for the current fiscal year (where i is the interest rate on debt before tax). Apart from a different financial structure, company B is identical to company A. Its Net Income will therefore be X-i*D*(1-T_c), which is strictly less than X and represents a tax saving of i*D – i*D(1-T_c) = i*D*T_c. Note that the fact that you are paying interests, i.e. that you are ending up with a lower income when your business is financed partly with debt, does not mean that you are losing money: the interests paid on debt represent an amount of money due to debtors, i.e. investors in the company who as such need to be remunerated. We will see that the average cost of capital for a company, that is to say the average return it must yield over a period in order to satisfy all its investors (shareholders and debtors) does not depend upon its capital structure when taxes and bankruptcy costs are not taken into account. When taxes are taken into account, you might end up saving money thanks to the tax saving which is mentioned above.

Is it sufficient to conclude that it is always preferable to use debt as a financing source ? No. One of the key reasons why this is not the fact is that a high level of debt induces a high level of risk for the company since debtors must be paid sooner or later, unlike the providers of equity (i.e. the shareholders) who will simply not recover their funds in the case where the investments undertaken turn out to be unsuccessful. This risk is called financial distress and can lead to bankruptcy (and in any case generates bankruptcy costs).