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Virtually every business owner wants to grow their business and increase profits. One way to do that is through leverage. But what is leverage in business and why is it needed? Simply put, leverage refers to creating opportunities via debt. In business, leverage often refers to borrowing funds to finance the purchase of inventory, equipment, or other assets. Is using leverage to start or expand your small business a good idea? It depends on what you plan to purchase with the borrowed money and how much debt you already have. Read on to learn how leverage works and when using leverage can be a smart business strategy.
What Is Leverage?When business owners need to buy something that they don't have the cash to pay for up front, they can either use debt or bring in outside investors to finance that purchase.If they choose debt, then they're using leverage. In many ways, leverage works like any other form of debt. The business borrows money with the promise to pay it back (plus interest), just like a credit card or personal loan. Debt increases the company's risk of bankruptcy, but if the leverage is used carefully, it can increase the company's profits and return on equity (the initial funds you invested in your business).The opposite of leveraging is bootstrapping, which is when a business owner saves up enough money to expand without taking on additional debt. Bootstrapping lowers risk because there aren’t any monthly debt obligations and you’re not at risk of losing any assets or collateral should you fail to make payments. The downside of bootstrapping is that it generally takes longer, can create missed opportunities, and may lower a company's return on equity.Recommended: What Are Common Small Business Loan Terms?
Leverage in BusinessThe concept of leverage in business is related to a principle in physics, in which a lever can give you a mechanical advantage in moving or lifting an object. In business, leverage involves using capital, typically cash from loans, to fund company growth. This growth could not be accomplished without the benefit of additional funds gained through leverage. In short, it provides opportunities where there once were none.For many small businesses, borrowing money can be more advantageous than using equity (such as taking on new investors) to finance transactions because it doesn’t involve giving up ownership stakes in the company.
How Does Leverage Work?Business leverage works by using debt to create wealth. An example of leverage is taking out a loan to open a new business location. As long as the return is greater than the monthly payment, growth has occurred, and the company used the additional debt to its benefit. Leverage isn’t unusual. Companies of all sizes use leverage for growth, as do individuals. For example, taking out a car loan to get to work is a form of leverage; incurring student debt to get a high paying job is another. However, the question of whether or not to use leverage for growth isn’t always straightforward because too much debt can lead to big problems. Should a small change occur in the business’s day-to-day affairs (or a big one, such as COVID-19), the business could easily be put into a situation where it would be unable to pay its monthly debts. When this occurs, a company is said to be insolvent. From here, it can either try to restructure its debt or close its doors. Because leverage can amplify gains as well as losses, it can be a good idea to weigh the risks and the benefits before adding to your business’s fixed liabilities. A general rule of thumb is that if the asset purchased with debt will earn enough (or, ideally, more) that the payments on the debt, and the value of the asset is unlikely to fall, leverage can be a great tool. Recommended: Applying for a Small Business Loan in 6 Steps
Example of Leverage in BusinessHere’s a hypothetical example of how leveraging could help a business expand. Pete’s Seafood is a food truck company that has been highly profitable the past year. Its owner, Pete, wants to purchase another food truck. Bootstrapping, or saving up, would take about four years, and he decides he wants to move sooner than this, so he takes out a small business loan.A new food truck will cost him approximately $75,000. With a loan term of five years and an interest rate of 6%, his monthly payment is around $1,500. However, he completely owns his first food truck and has no other monthly debts associated with that one.Both food trucks bring in around $2,800 each a month, for a total of $5,600. He always spends about 30% of his gross income on inventory, which takes his profits down to $3,920 ($5,600 - $1,680= $3,920). That amount minus his monthly debt payment of $1,500 means he is now netting around $2,420. Before he took out the loan he was only netting around $1,960 a month. By leveraging, he increased his profits by roughly 23%.
Types of LeverageThere are two main types of leverage, financial and operating. When most people think of leverage, they’re thinking of financial leverage (the above food truck scenario is an example of financial leverage). However, operating leverage also routinely comes into play in business.
Financial LeverageFinancial leverage is when a company takes out a loan from a bank or lender assuming the acquisition of the additional asset will bring returns that exceed the monthly payment of the new liability. In the food truck example, the owner used financial leverage to his advantage. The use of financial leverage to bankroll a business’s operations can improve the returns without diluting the company’s ownership through equity financing. Too much financial leverage, however, can lead to the risk of default and bankruptcy.Comparing small business loan rates is essential when using financial leverage to grow your business. The lowest rate ensures maximum profit for any new business venture.
Operating LeverageOperating leverage applies the concept of leverage to the cost of providing goods and services. It identifies and compares two types of costs in a company's structure: fixed costs and variable costs. Operating leverage is the ratio of fixed costs to variable costs.Companies with high operating leverage must cover a larger amount of fixed costs each month regardless of whether they sell any units of product.A car manufacturer, which typically needs a large amount of equipment to make and service its products, is a good example of a company with high operating leverage. When the economy slows down and fewer people are buying new cars, the company still has to pay its fixed costs, such as maintaining the equipment. When business is good, however, companies with high operating leverage can make more money from each additional sale because they don't have to increase costs to produce more sales.A company with fewer fixed costs and higher variable costs (such as a business that rents expensive equipment only when they have work) has low operating leverage. This type of business may have an easier time surviving difficult economic times. But if sales rise, so do their costs, which means they won’t bring in any additional profit.
Measuring LeverageOne of the financial ratios used in determining the amount of financial leverage a business has is the debt-to-equity ratio, which shows the proportion of debt a firm has compared to the equity of its owners. When a company is referred to as "highly leveraged," it means that the business has more debt than equity.For example, if you’ve invested $50,000 of your own money into your business, and have taken out a loan of $10,000, your debt to equity ratio would be 20% ($10,000/ $50,000 = 0.2 or 20%).Generally, the lower the ratio, the greater a company's safety. A debt-to-equity ratio greater than 40% to 50% is generally considered risky by financial analysts. So, in the above example, it would be considered low-risk to take on a small amount of additional debt. Recommended: What Capital Structure Is and How It Works
Pros and Cons of LeverageLeverage can be a powerful tool because it allows businesses to earn income from assets they wouldn’t normally be able to afford. As a result, leverage can multiply the value of every dollar of their own money they invest. But it can also be a double-edged sword. Since leverage means paying regular interest payment without any delay, it puts an obligation on the company to pay interest no matter what the business’s financial position is and, in the worst case scenario, it can even lead to the bankruptcy of the company.Here’s a snapshot look at the pros and cons of leverage.
|It provides the potential to increase the value of any of your own money that you invested in your business.||If the value of the investment made with financing fails to rise above the cost of financing, it can lead to business losses.|
|It increases the liquidity of the business, which can be used to buy new equipment/assets that can increase operational efficiency.||If the value of an asset purchased with the loan falls, it could become worth less than the loan (meaning you’d be stuck with debt even if you sold the asset).|
Leverage vs Margin: Main DifferencesIn finance, “buying on margin” is borrowing money from a broker in order to purchase stock. You can think of it as a loan from your brokerage. Margin investing can be advantageous in cases where the investor anticipates earning a higher rate of return on the investment than what they are paying in interest on the loan.Leverage is involved with margin because it entails using debt to increase profits – in this case, the broker lends the investor money to buy more securities than what they could otherwise buy with the balance in their account. Leverage in business, on the other hand, involves borrowing money from a bank or business lender in order to purchase assets. As with leverage in business, the leverage conferred by margin will tend to amplify both gains and losses. Should your securities underperform, you will have to deposit additional money to avoid the forced liquidation of other securities in your account.
Leveraged BuyoutsA leveraged buyout (LBO) is when one company takes on a large amount of debt to purchase another. Typically, the assets of the company being bought are used as collateral for the loan by the buyer. The idea is that the acquisition will immediately or soon produce cash flow greater than the monthly loan payments. The type of loan used to purchase a business is often referred to as a business acquisition loan.
The TakeawayLeveraging is the idea of using a tool to gain more momentum, success, or big results. Leverage in business involves using cash from loans to fund business growth through the purchase of assets. This growth would not be possible without the benefit of additional funds gained through leverage.You don’t have to be a big company to benefit from using leverage. When used wisely, it can be an essential strategy for an entrepreneur who wants to successfully expand a small business.If you’re thinking about using leverage to grow your business, there are a variety of small business financing options to consider. With Lantern by Sofi, you can compare rates from multiple small business lenders without any obligation.
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About the Author
Lauren WardLauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.