THE # 1 BUSINESS KILLER

The metric that has consistently spelled doom for businesses and how you can spot companies in trouble. Plus: A list of stocks to avoid now.

- Arul Selvan, Karthik Anand Vijay and Udhayaprakash

Although the word 'leverage' has multiple definitions, in the financial world, it translates into borrowing money. The word 'leverage' came from the word 'lever' which refers to a device that is used to amplify the input force so as to produce a much larger output force. When it comes to a company, the addition of debt to its balance sheet paves the way for boosting its shareholders' returns, as the same quantum of profits will produce a higher ROE (return on equity) for a levered company than one with no debt.

Why a company takes debt

Corporations are (as a class) probably the second largest borrowers in the world (after countries). Broadly, companies take on debt because of two reasons when a company goes through a rough patch, it needs to borrow money to endure it and the second scenario is when a company wants to expand its operations and lacks the resources to fully finance the expansion. To appreciate the different choices that a company has, it is critical to evaluate two costs: the cost of equity and the cost of debt.