In his 2010 Berkshire Hathaway Annual Letter, Warren Buffett discussed the importance of financial stability, drawing a parallel between auto racing and business: to succeed, you must first survive.
He warns against the risks of leverage, which amplifies gains but can lead to ruin when losses occur, as seen in the 2008 financial crisis. Leverage often tempts individuals and companies into overconfidence, but its dangers are significant, especially during credit shortages.
Buffett highlights that companies reliant on debt refinancing may falter when cash is needed to meet obligations. He likens credit to oxygen—unnoticed when plentiful but devastatingly absent when scarce, threatening businesses and economies alike.
Here’s an excerpt from the letter:
The fundamental principle of auto racing is that to finish first, you must first finish. That dictum is equally applicable to business and guides our every action at Berkshire.
Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious.
But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero.
History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.
Leverage, of course, can be lethal to businesses as well. Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid.
Occasionally, though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job.
Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that’s all that is noticed. Even a short absence of credit can bring a company to its knees.
In September 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close to bringing our entire country to its knees.
You can find a copy of the entire letter here:
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