AuthorAuthored by: Warren Tomlinson
A lever serves to amplify a force. Plyers, wheel barrows, boat oars, and even our own arms and legs amplify an input force to create an even greater output force. This is the essence of leverage. In the financial world, leverage is more narrowly defined. In business financing, leverage is a strategy that revolves around borrowing money (debt) to create a disproportionate return than you could have created with your own current asset base.
For many small companies, debt is the primary source of funding. Selling equity too early will result in a loss of ownership disproportional to what you think your company will grow into, and self-financing might not be possible. If Jeff Bezos financed through equity early on, he wouldn’t be worth nearly what he is today thanks to his shares in Amazon. If he only used what he owned, then Amazon wouldn’t have grown at the rate that it did.
The two advantages of financing through debt is that it can enhance your earnings and it will give you a favorable tax treatment since interest expense is tax deductible. Debt is a powerful tool if used correctly. There is no shame in trying to minimize your debt levels, that is a conservative approach that will minimize your risks, however, debt shouldn’t always be feared either, rather understood. It’s a tool, and it has pros and cons worth understanding, especially if you are trying to grow quicker than you are in your current state.
Let’s look at an example of how leverage can amplify your returns.
Scenario 1 (No Leverage): Your company uses $500,000 of its own money to buy a factory. So no leverage is used and no interest payments need to be made. The next year your business generates $200,000 in profits directly thanks to your investment. After one year, you would have a 40% return on your investment. ($200,000 in profits/$500,000 initial investment = 40%).
Scenario 2 (Leverage): This time your company uses $100,000 of its own money and $400,000 in debt to buy the same factory. Let’s say the factory generates the same $200,000 in profit, but after interest payments are made, that number goes down to $175,000. The return you make on your investment is 175%. ($175,000 in profits/$100,000 initial investment = 175%). If you wanted to at this point, you could re-sell the factory, pay off your debt instantly, and you’d be up $175,000 with no skin in the game and all you needed was $100,000.
Unfortunately, leverage is a double-edged sword. In the same scenarios above, if you incurred a loss of $200,000 before any interest payment, the roles would be reversed and you would suffer a 40% loss without debt and a 225% loss with the debt financing and interest payment. The disadvantages of debt revolve around the risk. If things don’t go the way you want, then your losses will be disproportionally blown up and you may not have the assets needed to cover your debt payments, resulting in bankruptcy. Likewise, if you start to accumulate too much debt compared to your own assets, then debtors will demand higher interest rates to compensate for the higher risk of bankruptcy you’re incurring.
Financial leverage can be a risky game, especially if your business is cyclical or has low barriers to entry. If, however, your business is steady and the future is cut in stone, then perhaps your business can more easily justify leverage. Like most things in life, there is a natural balance. Finding the right amount of leverage for your business can be difficult and risky without the proper help.
Here at the SBDC, we are available to discuss leverage. While there isn’t a perfect answer for what everyone’s leverage should look like, one of our Certified Business Advisors would love to help you find a leverage ratio that is right for you or point you in the right direction.