Quite often it takes an event for people to wake up and realise that something they thought was a good thing isn’t actually the case. The coronavirus, and the lockdowns that followed, has been such an event in so many ways. It has laid bare the strength or otherwise of company business models, but has also served to shatter the theory that debt and share buybacks make shareholders richer.
Borrowing money to finance a business adds financial gearing or leverage to a company’s trading profits. This means that the change in trading profits will magnify the change in pre-tax and post tax-profits. This gearing works both ways and is great when the company is growing its trading profits, but can be very painful when they are falling.
Investors need to understand how financial leverage works for and against and should never let it fool them that a business is performing better than it really is. This often gets forgotten in an upswing, but a painful lesson is then learned when trading turns down.