Question

Q: How does the cash flow volatility of a company influences the amount of debt a company can manage successfully? Discuss this relationship. What other factors that could influence a company taking on additional financial leverage?

I have attempted to answer it as follows, is my answer accurate?

A: Higher cash flow volatility leads to periods in which the firm has insufficient cash flow to manage its debts. Firms with high cash flow volatility (i) use less debt, (ii) are more likely to use zero debt, and (iii) use shorter maturity debt. Therefore, cash flow leverage is negatively related to financial leverage. Other factors that influence leverage are: the size of the firm and its industry, its profitability, or its working capital.

Answer 1

Your answer is pretty accurate. I would addon further to the answer;

Debt requires regular payments for Interest and Principal based on the amortization schedule. If any company has high cash flow volatility, it might lead to non-payment of debt obligations when they are due. Thus, leading to default in the debt market - reducing the credit rating and lowering the financial leverage for the firm.

Therefore, it can be said that the firm should use less debt when they have high cash flow volatility. Debt obligations also put pressure on the future growth prospects of the business, as they are regular and mandatory high cash payments.