COVID-19 was public enemy #1 last year, wreaking havoc on businesses across the country. Business owners were faced with declining revenue, operating losses, and layoffs. Many business owners who had never been through a recession before were devastated, overwhelmed, and anxious as they dealt with cash flow issues they had never faced. They weren’t sure if the decisions they were making were helping or hurting.
First, what is leverage and what should I know about it? Leverage is the use of debt to allow a business to earn income through assets it wouldn’t normally be able to afford. For example, if I had a line of credit for $200,000, I could sell an additional $200,000 of products and services. If my net profit margin was 10%, that would be another $20,000 of profit for my business. However, the use of debt increases the financial risk of the company.
Increases in leverage are usually caused by an increase in debt or a decrease in net worth. The decreases in net worth can be caused by excessive distributions or operating losses. The company experiences a double whammy when either of those is funded by an increase in debt.
Some years ago, I worked with a client who had balance sheet leverage of $8 of debt to every $1 of equity. This client had to borrow against the receivables and pay 24% interest for money that shouldn’t have been taken as owner’s distributions. The next 18 months were tough as this owner took a salary only and built equity. They were able to obtain a bank line of credit to reduce the interest rate to 4%, putting 20% interest savings back into the company.
Leverage defined as total debt/total net worth should be tracked as a key performance indicator (KPI) on your financial scorecard. If you’re attempting to obtain a bank line of credit, your leverage should be less than $3 of debt to $1 of equity or 3-1. A higher leverage ratio could make you unbankable and many banks have a leverage covenant as part of their loan agreement with their clients.
COVID stole profits from thousands of businesses all across the country. Without PPP loans, many of those businesses would’ve failed creating massive layoffs. Many business owners make the mistake of only looking at their income statement. Without looking at your balance sheet too, you may be unintentionally exposing your company to excessive risk because of high leverage.
In addition, once a year, every business owner should put their company through a financial health check-up to spot any undetected changes in profitability, liquidity, and leverage. Undetected factors, like leverage, may be contributing to poor performance and left undetected, will likely get worse.