What is leverage? Leverage is the use of borrowed money to increase sales and profits. It is measured as a ratio of total debt/total equity. The greater the amount of debt, the greater the leverage you have in your business.
I think I bring a unique perspective to this topic because for 32 years of my career, I made loans so business owners could use leverage in their business. Now, for the past 8 years, I’m a “recovering banker” turned entrepreneur who has to use leverage in his business from time to time.
Here are three things you must know about leverage:
1) A loan allows an organization to generate more earnings without an increase in equity. It’s hard to raise capital for your business. Most investors have a minimum amount of capital they will invest and most want control in exchange for their investment. Plus it’s usually very expensive money. Rates of return can be in the 20’s-30’s% annually. Business owners may have their assets invested in other places and just don’t have the liquidity to put more money in their business. Since interest is a fixed cost, it can be written off against profits to reduce net income.
2) During boom periods, leverage can be beneficial because sales and profits increase at a much higher rate using debt than just using internally generated funds.
However, the reverse is also true. When you borrow, you assume that sales and profits will continue to rise and there will be ample cash flow to cover the loan payments. High leverage may cause serious cash flow problems in a recessionary period, because there may not be sufficient sales revenue to cover the interest payments. If the bank declares a default, then you will be forced to come up with the principal portion of the loan as well.
In some cases, business owners refuse to borrow money for a variety or reasons and will finance their businesses either with internally generated funds or funding the business out of their personal pocket. In this case, they could be missing sales and profit opportunities by not using leverage in their business and paying the price because of it. So is there a happy medium?
3) The most common source of borrowing money is from your local bank. While the amount of leverage can differ based on the industry, the banker’s rule of thumb is no more than a leverage ratio of 3-1, total debt/total equity.
That means your bank and your vendors are taking about 2/3 of the risk in your business based on the debt and you’re taking about 1/3 of the risk based on your equity. You’ll often see a leverage covenant in your commitment letter from the bank for this very reason. Hopefully, you’ll see this as a good guideline.
What are your thoughts about leverage? How do you use it? If you’d like to discuss your particular situation with one of our advisors, please get in touch.
