Use financial debt to your advantage
Watch the webinar, “Leverage Doesn’t Have to be a Dirty Word.”
At my company, we deal with plenty of entrepreneurs who are a bit gun-shy when it comes to taking on debt.
Some — especially those who question the viability of their business — fear getting caught in a debt spiral that eventually leads to bankruptcy. Others question the need to take on debt when their business is already thriving. Still others simply don’t have the stomach for it.
But debt and leverage (i.e., debt used for investment purposes) don’t have to be bad things. In fact, they can be quite helpful if used properly. Consider the following example: If you could borrow money at 6 percent and invest it to earn 12 percent, would you do it? Chances are, you would.
So, why would a business use leverage? The main reason is to prevent the business from using too much of its equity to fund operations. Or, as accountingtools.com puts it: “Financial leverage is favorable when the uses to which debt can be put generate returns greater than the interest expense associated with the debt. Many companies use financial leverage rather than acquiring more equity capital, which could reduce the earnings per share of existing shareholders.”
Leverage may allow a business to make a favorable return on its assets. Also, interest expense is often tax deductible. That reduces the borrower’s overall costs. Financial leverage also has a multiplier power.
Consider these examples:
- Company X spends $1 million in cash to buy 100 acres of land. It is not using leverage.
- Company Y spends $1 million in cash and also borrows $2 million to buy 300 acres of land. The company is using financial leverage because it is controlling $3 million worth of land, but only using $1 million of its money.
Now, say these properties increase in value by 50 percent and are sold.
- Company X makes $500,000, which is a 50 percent return.
- But Company Y makes $1.5 million, and its return on its $1 million investment is 150 percent.
As an added bonus, the successful use of financial leverage may improve a firm’s credit rating. That means future loans may be obtained at more favorable rates.
Acquisitions, buyouts, one-time dividends and share buybacks (i.e., situations with specific objectives) are all ideal for using financial leverage.
Of course, as with all things in the financial world, there are risks. A major risk is rising interest rates. And considering how low interest rates are these days, it’s reasonable to expect that they will rise versus decline. Another risk is the decline in value of assets. Just as there’s a positive multiplier effect, there also can be a negative one. In addition, it can be costly to use leverage. Investors assume greater risk, which requires higher interest rates.
The use of leverage isn’t necessarily simple; it may require the use of complex financial instruments. Concepts such as subordinated mezzanine debt may be difficult to understand.
There are no guarantees in life and no two situations are the same. However, depending on your circumstances, it may be valuable for you to use financial leverage. Figuring out those circumstances can be difficult, which is why consulting with a financial advisor is of paramount importance.