Have you ever tried to drive a nail into a piece of wood by holding the top of your hammer’s handle, close to the hammerhead? It’s difficult to get the power you need. If you move your grip toward the bottom of the handle, however, you get the force and momentum to sink the nail into place. By holding the hammer in the right position, you create leverage, which increases your ability to perform the task at hand.
Just as leverage can work to your advantage when hammering a nail, financial leverage can be a powerful tool to accelerate your business. When used properly, it can help you expand, make purchases to enhance operations, and even take on new endeavors. Financial leverage does require taking on debt in order to grow, so understanding this type of financial strategy — and the benefits and risks associated with it — is key.
What is Financial Leverage and How Can it Help Your Business?
The textbook definition of financial leverage, from the Corporate Finance Institute, is: “The use of borrowed money (debt) to finance the purchase of assets with the expectation that the income or capital gain from the new asset will exceed the cost of borrowing.”
Simply put, financial leverage is when you borrow money from a lender, such as your bank, to purchase assets that will help your business earn more income long term. Here’s an example:
An asphalt contractor wants to increase his earning potential by adding another truck to his fleet so he can take on more jobs. A truck costs $50,000, which he knows he can make in cash over a period of a few months. However, if he uses all of his cash to pay for the truck in full, he won’t have the money to operate his business.
He decides to get a loan through his bank to finance the truck.
Now, he can use his cash to continue paying employees and meeting operational needs, and he’s gained a new piece of equipment that will help him bring in additional income. For the life of the loan, he uses the extra income from the truck to pay the principal and interest due each month. When he pays the loan off, he removes it as a liability from his balance sheet and applies the extra income from the truck directly to his cash column.
He has successfully utilized financial leverage to grow his fleet of equipment and his revenue. While he assumed debt for a while, it paid off in the long term.
How to Use Financial Leverage Cautiously
As we just learned, financial leverage can boost your business, but you have to be thoughtful and careful when using it. All business investments and strategies have risks, and financial leverage is no exception. You can manage the risks by:
1. Matching the type of loan with the purpose of your financing, or to the life of your asset.
To explain, let’s continue with our asphalt contractor example: The business has grown and he’s decided to buy a building to store materials and equipment safely. A building is a large asset, one that typically requires more time to pay off. In this case, a long-term business loan is more appropriate than a short-term loan.
Here’s why. A long-term loan allows the asphalt contractor to spread out the cost over time, whereas a short-term loan most likely would require him to pay it back within a year by making much larger monthly payments. A year wouldn’t give him time to accumulate enough income to make those payments plus pay for his operating expenses. He would be over-stretched.
2. Keeping your leverage ratio in check.
Your leverage ratio compares your liabilities (your debts, or what you owe) to your assets (what you own that generates value). Your ratio gives you a solid indication of whether your business can meet its financial obligations.
Being highly leveraged (meaning you carry a lot of debt) can overburden your cash flow because you have to make payments toward those debts every month. This can be especially challenging if your business operations don’t go as planned and you don’t generate as much in income — perhaps the weather is bad for several weeks in a row, and our asphalt contractor gets behind in his jobs, for example.
Experts have identified appropriate leverage ratios for different industries. Your lender can help you determine your ratio to see if it’s in line.
A Final Takeaway
One of the best ways to accelerate growth within a business is to correctly utilize financial leverage. Your lender can partner with you and your business to make sure you’re weighing all the risks and choosing the right loans.
Spencer Richins is a senior vice president team lead/commercial lending at Bank of Utah’s Bountiful branch. He has worked for the bank since 2010. He is a graduate of the Pacific Coast Banking School, Utah State University and Weber State University.