Any successful business owner will tell you that you can’t stimulate effective growth without savvy procurement of assets– but how do you get the capital to invest in these assets if you don’t have any to spare?
The answer is leverage – and while it’s a simple principle, using this strategy effectively can be the difference between your business growing exponentially and failing at key opportunities.
SO, WHAT IS LEVERAGE?
In physics, leverage describes how one can use a lever to gain a mechanical advantage when lifting an object due to torque – similarly, in business, leverage involves a business owner gaining an assist to help lift their business higher than they would be able to normally. This financial “assist” comes in the acquisition of capital, quickly, typically in loans, to fund business development and company growth through the selective purchasing of assets. The growth that results from this could not have been accomplished without the help of the loan. Additionally, although this is less common, leverage can simply refer to any situation in which a business used something to achieve more than they would have been able to without it. So, while businesses can leverage debt, they can also leverage their assets, political connections, fanbase, or social media presence.
HERE’S AN EXAMPLE TO SHOW YOU HOW IT WORKS
A clothes retailer in a shopping mall is struggling to grow their business due to space – they need a bigger store in order to increase their stock and therefore expand their business. They notice that there is a recently vacant space next to them in the shopping mall, but they don’t possess the funds in order to pay for the rent there. Additionally, the retailer would need to purchase clothing stands, lights, signs, and other additional items that are necessary for their store to stand out.
So, in order to pay for all of this, the retailer takes a cash loan from their local bank, and uses the newfound capital to finance all the necessary purchases that are required for them to expand their store into the new space. In this example, the loan the retailer took out is leverage – the necessary influx in capital that allowed for expansion and growth. As you can see here, leverage can be vital in growing your business, especially for smaller companies.
HOW DO I USE IT EFFECTIVELY?
It’s important to understand that if leverage is not properly handled, it can be a financial disaster. Investment analysts and accountants will measure leverage using a financial tool called the debt-to-equity ratio, which determines the amount of debt a business possesses compared to the equity of the owners. This will, in general, be shown on the business balance sheet.
We won’t focus on how to determine this ratio in this video, as it can be an in-depth topic that would require its own video itself. However, as a rule of thumb; any debt-to-equity ratio that exceeds 40 to 50% should be carefully monitored. As a side note, the debt-to-equity ratio does not just apply to leverage – it can be beneficial to always keep an eye on how yours is going, as well as the ratios of other businesses in your local area.
Additionally, leverage doesn’t have to come solely from loans. As another example, you can use trade credit – using vendors as creditors – to leverage your company’s credit record. Another benefit of leveraging is the impact it can have on your credit record – building your business model around repaying debt early on can really save you in the long run if you’re in desperate need of cash in the future. Also, with debt financing, the interest payments are tax-deductible.
THE TWO TYPES OF LEVERAGE
Businesses can be leveraged using either financial leverage or operating leverage.
This type of leverage is the type that we explored in the hypothetical example, i.e. borrowing from a bank or other lenders. These forms of leverage will generally involve quick acquisition of capital to purchase assets. Bankrolling an organisations operation can improve returns to shareholders without running the risk of diluting the firm's ownership through equity financing. However, too much financial leverage, increases the risk of default and bankruptcy.
The concept of operating leverage applies to the cost of providing goods and services. The breakeven analysis technique identifies two types of costs in a company's structure, fixed and variable costs. The ratio of fixed costs to variable costs is then defined as operating leverage.
A business is said to have high operating leverage or a capital-intensive firm when it has more fixed costs as compared to variable costs. For example, consider any companies that relies upon manufacturing, such as car manufacturers, which has a consistent stream of expenses as mass amounts of cars are built. When the economy slows down and fewer people are buying new cars, these companies still have to pay their fixed costs, such as overhead on factories and depreciation on equipment that sits in the warehouse.
This is considered leverage even though the equipment may be listed as an asset on the balance sheet, there are continued fixed costs associated with acquiring and maintaining that equipment. These fixed costs are paid because ideally, the assets acquired will be leveraged to turn a profit.
The opposite of a capital-intensive firm is a labour-intensive firm. One of the benefits of a Labour-intensive company is that they have fewer fixed costs, however, they require greater human capital for the production process. Service businesses, such as restaurants and hotels, are labour-intensive. In difficult economic times, labour-intensive firms typically have an easier time surviving than capital-intensive firms.
As the name would imply, combined leverage aims to describe all business risks affecting the company. It considers both operating leverage, which measures the fixed costs and assets, and the debt financing measured by financial leverage. As a result, combined leverage also holistically describes the total amount of leverage that shareholders can use to borrow on behalf of the company.
SO, IS LEVERAGE A GOOD THING?
If done right, absolutely. The problem is, if managed poorly, it can be devastating for any company. Much like with any loan, if you can’t pay it back, you’re in danger. Taking careful consideration of factors such as your debt-equity ratio and your ability to pay back loans can result in leverage being incredibly useful in you scaling your business model. Additionally, it’s crucial that you make a plan for what exactly you intend to spend the capital on – it's pointless to leverage if you don’t understand precisely what assets you will invest in and the direct impact that the procurement of those assets will have on your business growth.
Additionally, it’s important to understand the different impacts of financial and operating leverage. One (2003) study showed that "Leverage from operating liabilities typically levers profitability more than financing leverage and has a higher frequency of favourable effects." This makes sense, as when you borrow from suppliers, it’s usually in smaller amounts and so can be paid back faster, compared to traditional bank loans which are generally larger and are repaid in the long-term, resulting in far more devastating impacts if you default on the loan for whatever reason.
There is another use of leverage that is high-risk but can be enticing to consider. A leveraged buyout is the process of purchasing a business using leveraged money, with the assets of the company being used as collateral for the loan. This use of leverage relies on the idea that the newly purchased business will be immediately profitable and will result in a return on investment that is enough to be financially stable. If you are a small business owner, this idea should not tempt you – you should worry about your own business’ growth for now. However, you should be aware of the concept.
By now, you should have an understanding of leverage, both financial and operational, and the potential benefits it can have for your business as it grows and expands. But remember, with great financial power comes great financial responsibility, so take caution when using this powerful tool within your business, planning accordingly and accounting for any potential risks and threats.