We’ve been talking about how running a business is like baking or cooking. You need all the right ingredients, in the right proportions, cooked at the right temperature, for the right amount of time.
Every business owner wants a business that’s perfectly “cooked”, with lots of cash flow and profits and collecting receivables well. If you want to catch up on the other “ingredients”, you can check them out here: profitability, activity, and liquidity.
The next ingredient, leverage, is a little tricky. There are two types of leverage, financial or operating. We’re going to talk about financial leverage, which is how much debt versus equity you have in your business. Think of it like hot sauce; you don’t want too much or too little.
A friend of mine, Tom, loved hot wings and ordered them often when we would go to dinner together. At the time, there was a restaurant that had a hotter than hot version of wings called Three Mile Island, named after the nuclear reactor that had a partial meltdown back in the 70’s (I know, I’m dating myself). Tom had red hair and a fair complexion and would always turn beet red and sweat profusely every time he had those wings. The hot sauce, like leverage can be, was a little too much and hard to handle.
Leverage uses debt to grow your business instead of using cash from profits. It allows you to run your business “hotter” or riskier. Leverage magnifies profits, but it also magnifies losses too. When cash flow slows down, leverage magnifies the losses because you may not be able to cover operating expenses and certainly can’t cover debt payments on top of that. When Covid hit, can you imagine how many more business would’ve failed without the help of PPP loans or payment deferrals offered by banks?
When business owners aren’t careful, leverage can creep up on you. We love the convenience of a credit card, but unless we’re paying off the balance every month, that balance creeps on you. Then the interest charges kick in and we’re shocked that we owe that much. Borrowing money to run your business can be the same way. You have a loan for a building or equipment, you have a line of credit that you draw on for monthly expenses when needed, your collections on accounts receivable may slow down, and pretty soon, your debt to net worth is much higher than you realized.
So, how do calculate financial leverage in your business?
Financial leverage is calculated by dividing total debt by total net worth. It’s also called a debt to net worth ratio. If your debt and net worth are about the same, your leverage ratio is 1-1. If you have twice as much debt as net worth, then your leverage ratio is 2-1.
So, when does leverage start becoming “hot”? If you’re borrowing money at your bank, then they will tell you 3-1 leverage is about their limit. Yours may be different; it can depend on the type of business you’re in. Manufacturers have more equipment to manufacture products, so their leverage may be higher than other industries.
Is your business running a little hot? It’s hard to know which ingredients need to be adjusted to help your business come out “just right”. You don’t have to do it alone. Let’s talk.