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Leverage A Primer What the Heck Is It, and What Does It Mean to Me? Al Walsh Walsh Enterprises Business & Financial Advisors Huntington Beach, California USA http://www.awalsh.us [email_address] (714) 465-2749
Leverage is a word that’s been thrown around a lot in recent years. Some people new to the business world don’t understand it’s use. It has different meanings for different situations, but here’s a basic primer to help you understand it’s primary application.
At it’s core, leverage involves using someone else’s money to boost (or leverage) your ability to do business. Every business needs money to grow, and opportunities can be lost if all we rely on is internally-generated profits. At some point in time, most businesses borrow to grow. What could an extra $million do for your business?
Such borrowing can take the form of a straight bank loan, or other forms such as Preferred Stock offerings that require payback.
Straight investment, such as Common Stock investment that does not have payback strings attached, does not constitute a form of leverage. In such cases, you are adding an asset (money) to the company without recording any corresponding liability. This is the preferred method of raising money if you can find willing investors. Of course, the trade-off is that you give up partial ownership of the company. Some owners prefer the debt method to maintain their ownership interest & control. Most companies utilize a combination of the two methods.
Leverage is a “double-edged sword”. On the one hand, you are utilizing the money to grow your business. But that money has to be paid back, with interest, and you can get into trouble rapidly if the increased business is not there to support the debt repayment. Borrowing usually involves committing assets as collateral (such as receivables, equipment, and inventory). If you fail to meet your payment obligations, the lender will go after those assets to protect themselves and you will no longer have a viable business.
For years, the policy of the Federal Reserve has been to provide “cheap money” to spur the economy. Businesses took advantage of this at record levels. In many cases, businesses were borrowing to acquire other businesses. This is why you heard so much about Leverage and Leveraged Acquisitions. Now, with the recession in play, we’re experiencing a de-leveraging as banks reduce borrowing lines, private investors run for the sidelines, and new businesses find that they can’t access money.
Of course, the same principals spelled out here apply to individuals too. When you borrow, you leverage your personal financial position and put your personal assets at risk.
Leveraging yourself can be an overt act, or it can be a subtle event over time. You may go out and borrow money as a deliberate act to finance business expansion. You might also tap your credit line for cash flow because your customers aren’t paying, or because your profitability is declining. This second creeping form of leverage has the same effect as the more overt form; the difference being that your internal cash flow from operations is declining and may not be sufficient to repay the debt. When you leverage, you have to be very careful not to over-commit beyond your reasonable ability to repay given economic and market conditions; which can change rapidly.
In Finance, leverage is measured via ratios which compare debt to assets –or- debt service (payment) requirements to income & cash flow. The higher your debt is as a ratio against assets, or the higher your debt service requirements are against income & cash flow, the more you are leveraged. Such ratios tend to focus on those assets which can easily and quickly be converted to cash. “Dead” assets, such as slow-moving inventory, aren’t of much interest to the lender as a form of collateral. They focus on those assets which they can easily and quickly liquidate in case you default on the debt.
In macroeconomics, leverage on a national level is measured by total borrowing against Gross Domestic Product (GDP). If debt goes up while GDP goes down, the country gets into trouble in a hurry. We must produce to pay.
So there it is. That’s leverage in a nutshell. It’s a useful tool that most businesses utilize at one time or another. Most established businesses have an ongoing borrowing line. On the other hand, it can quickly dismantle your business if you get in over your head and end up defaulting.
Again, the same rules apply to individuals. Most of us take on debt at one point or another for major purchases such as houses and cars. It can be a useful tool. But if you borrow more than you can repay, your financial situation will deteriorate rapidly.
Be careful how much you leverage yourself & your business. Banks & other lenders usually have rules they follow to restrict lending & help prevent over-leveraging, but it doesn’t always work. That’s how we got into the current economic mess. Too many lenders loaned money for houses that people couldn’t repay. Then the economy took a dive and even responsible borrowers found themselves in trouble because of declining house values and lost jobs.