So What Is This Financial Leverage Thing Anyway?
To understand leverage, think of a crowbar. If you want to move a heavy object, such as a large rock, you can stick a crowbar under it. Raise the crowbar, and you are able to move the rock. But why is it so much tougher to move the same rock with your bare hands? After all, in both cases, it is your muscles at work. The answer lies in physics: the crowbar acts as a lever and amplifies your power. The operative word is “lever.” In pretty much the same way, financial leverage acts as a lever that amplifies the financial outcome of a business. That is what makes it a fascinating, though risky, tool for financial management.
Understanding the Basic Math Behind Financial Leverage
The textbook definition of financial leverage goes something like, “using borrowed funds as a tool to enhance shareholder returns.” A popular formula to measure financial leverage is total debt divided by shareholders equity. But neither of these theoretical approaches captures what small business owners need to understand about financial leverage. For that, let me use an example:
Financial Leverage in Action
To achieve a business objective, you need to spend $100,000. The business objective could range from setting up a cupcake shop to developing an e-commerce website to putting together the supplies needed to start a cleaning service. For simplicity’s sake, let us assume that in a year, you will have achieved sales of $150,000. To compute how much in returns was generated, consider two approaches:
Approach 1: You and your business partners pool in the $100,000. This amount is called the owner’s equity. At the end of the year, you make a surplus of $50,000, thereby making a return of 50%.
Approach 2: You and your partners pool in $40,000 and borrow the remaining $60,000 at a 15% rate of interest. At the end of the year, you repay the loan along with an interest of $9000 (15% of $60,000). You are now left with $81,000 ( $150,000 minus $69,000). So an investment of $40,000 generated a return of $81,000, more than 100%.
Isn’t it fascinating that for the same input ($100,000) and output ($150,000), we ended up with a 50% return on investment in one case and a 100% return in another? The difference arose because the second approach used financial leverage by borrowing money.
If you create a third approach, say, investing only $10,000 and borrowing the rest, your returns would still be greater.
So, Is Financial Leverage Good or Bad?
The above example might convey the wrong impression of financial leverage. I liken it to an amplifier. If you make a profit, financial leverage enhances that profit. But if you make a loss, financial leverage increases the loss too.
Financial leverage is undoubtedly a double-edged sword. Business owners plan for success, not failure. As a result, they tend to be more willing than they should be to expose themselves to the risks associated with financial leverage. But regulators, lenders, rating agencies, auditors and others who evaluate the financial health of a company tend to pay special attention to the degree of financial leverage of your business.
Didn’t Excessive Leverage Cause the Global Economic Crisis a Few Years Ago?
That is largely true. Banks and other financial institutions were highly leveraged before the crisis that exploded in 2007-08. Given the high degree of financial leverage, the collapse was also highly catastrophic. And since financial institutions are interlinked, we saw a cascading effect that led to across-the-board bankruptcies.
Should Small Business Owners Care About Financial Leverage?
Small business owners should think of financial leverage as a tool for growth. A moderate amount of leverage is a good idea. This is because a loan can eventually be retired by repaying the principle and interest. But equity capital, regardless of whether it comes from founders or investors, does not retire easily.
The problem with my advice to use moderate financial leverage is that there is no clear benchmark for “moderate.” If you end up with a profit, you regret not having leveraged more. And when you face a loss, you blame financial leverage for the extent of damage. But now that you know the pros and cons of financial leverage, you can make an informed decision on how you want to use it.
Ajeet Khurana is CEO of the Society for Innovation and Entrepreneurship (SINE) at IIT Bombay, India’s premier engineering school. A famous entrepreneur, mentor and angel investor, Ajeet comes with extensive startup experience to his credit. From starting two ventures as a solopreneur, to helping a large number of startups with their go-to-market, he has never shied from getting his hands dirty. At the same time he has helped dozens of startups raise investment. He truly believes that small business owners are driving change in the world, and need to be facilitated as much as possible. Innumerable small businesses have gained from his attitude, vast professional networks, financial acumen and digital mindset.