In this post, I will teach you how to use Leverage. So what is leverage? This is a strategy that means to borrow money to buy assets of a business. Doing so gives the business power to do what it will not be able to do using its owner’s equity. For instance, it can expand its business; it can even buy another business using leverage. Also, you have two types of leverage, the financial and operating leverage. You can use both to give your business the funds it needs to succeed in its line of business. A business can also raise money in the capital market through equity from investors. Finally, leverage is the size of debt a business uses to finance its assets. So to go a bit further, allow me to show you how to use leverage for your business.
How To Use Leverage
The meaning of leverage in Business
This concept in Physics means using a lever to give the person using leverage a mechanical advantage to lift objects. If there is no leverage, you won’t be able to lift that object. But in a business, you use leverage to buy assets to stimulate growth. Also, cash assets are mainly cash loans to finance the development or growth of a company. You should note that for most small businesses, you cannot buy these assets without a loan or extra money. And this loan is called leverage.
How does Leverage Work?
As you consider how to use leverage, you should find out how leverage works. Most businesses always operate with little funds. They are usually unable to do any project without extra help from a financial institution.
For example, if a retail business wants to hire a new shop space, in most cases it cannot do this on its funds. Why? It will be added cost to its initial capital expenses for rent, furniture and fittings, shelves, and inventory and so on.
To be able to expand to that new shop space, the retail business now goes to its bankers and applies for a business loan. That loan facility is called leverage. That loan will now allow the business to do what it could not have done without a lever or additional funds.
Why you need debt to run your business
From that short example about how leverage works, you can see the value of leverage for any business. Other ways on how to use debt to take advantage of opportunities a business sees include the following:
- When you use debt, interest payments on that debt are tax-deductible. In some cases, you are allowed to write off a bad debt.
- Borrowing gives your business the cash flow it needs to pay for equipment. It also gives you the capacity to pay your staff with ease.
- Some businesses find it cheaper to borrow to run the business. So in that case, it is preferable to borrow.
- Also, a business can grow fast and expand quickly if they have a large pool of funds from borrowing instead of waiting to save enough cash to expand the business.
- And, most businesses need debt when they are just starting to enable them to stay as a going concern. Without debt many startups will fail.
You can use the debt in two ways
Financial leverage comes when you get a facility from a traditional bank. While operating leverage arises from trade financing and payables. Also, when you borrow from financing activities with suppliers, you pay it back faster. But when you borrow using financial leverage from banks, you pay the loans later.
What is Leverage Buyouts?
Leverage buyout is another way on how to use debt. Leverage buyout allows you to buy a business using borrowed money. Also, you use the assets of the company you buy as collateral for the loans. Besides, it is expected that the assets of this company you bought will quickly generate enough cash flow to repay the loan.
What to avoid when using leverage in your business
Borrowing could lead you into a ditch. When you borrow more than you need for your business you give yourself a problem. The amount you borrow should just be adequate. Don’t take a facility you do not need.
Also, you should know the time your business will be able to repay the debt it is creating. It is a normal thing for a startup small business to start with the owner’s equity or the founder’s funds. So you should also separate your personal affair from that of the small business so that you don’t use the business funds as if it is your personal money.
Just note that the amount you borrowed or (creditors like a loan from a bank or credit card loan) must be repaid.
How to measure debt to equity
Measuring your debt to equity is an important factor you must consider if you want to learn how to use leverage. Accountants measure leverage using this tool called debt to equity ratio. This tool measures the total amount of debt in business in comparison to equity or the amount the owners contributed to the business.
To find out what the level of debt a business has, look at the liabilities and add short term debts. Plus the current debts due in one year or part of long term debt, and the actual long term debt. For example, let us assume that all the liabilities total $350,000. Now check the owner’s equity in the balance sheet plus the retained earnings. Also, let us assume the equity of owners is $600, 000.
Therefore, the Debt to Equity ratio formula is Total Debt divided by Total Equity. In this example, it will be 350,00/600,00 = .5834 or 58.3% this shows that the debt is 53% of the equity.
In accounting for business, the lower the ratio the safer the business will be. The rule is that debt to equity should not be greater than 40 to 50%. If it is more than 50% then the company must watch its operations carefully.
In this article, I explained how to use leverage to run your business. I also told you why you need leverage and how to use it. Besides, you learned about how much debt you should have as a business. in addition, you now know how to calculate debt to equity of your business. Use this to leverage your business operations to profitability.