A look at financial leverage : How it can help your business grow
January 04, 2023Whether you need money to invest in infrastructure, pay staff, or for purchasing inventory for your business, you have to face difficult decisions on the best way to close the gap between the capital you need for expanding and covering your debt. There are many methods that you could use to help your business grow and manage this gap, there are loans like bridge loans, ways of using equity and more. Today we will look at financial leverage, or just leveraging. This is a way that has a lot of potential for giving your business opportunities to finance it and expand it.
Leverage in business
For starters, the concept of leverage in the business area is related to a principle in physics, where it refers to the use of a lever that provides the user with a mechanical advantage in lifting or moving objects. This kind of task, without leverage, couldn't be done. Leveraging is a concept that is used both in business and investing situations. In business, the term refers to how a business acquires new assets for an expansion or a startup. The concept can be used as a verb as in "companies leverage themselves using loans for expanding their reach" or it can also be used as a noun as in "Leverage is a way to permit a business to grow".
So, when someone says that a business is leveraged, they mean that the business has borrowed money for financing the purchase of assets. A business can also use leverage through equity by raising money from investors. Leverage involves using different assets, usually in the form of cash coming from loans, to fund company growth and general development in a quite similar way through the purchase of assets. This growth couldn't be obtained without the benefits that additional funds gained through a leverage process can provide.
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How does leverage work?
A good example for how it works: Let's say a small retailer wants to expand into an available space nearby in a strip mall. In addition to an increase in rent, the business will have to buy shelves, tables, fixtures and some other necessities required for operation. Plus, it will require additional inventory. Typically, most small businesses don't have enough cash on hand to cover all of these expenditures, therefore the retailer applies for a business loan. This loan is what leverage is. It allows your business to do what it couldn't do without the additional funds.
Wait, but is it a good thing to do?
Yes, leverage can be a good thing, provided that the business doesn't take on too much debt and is unable to pay it all back. Still, you need to know what a 2003 study showed: "Leverage from operating liabilities typically levers profitability more than financing leverage and has a higher frequency of favorable effects. This makes sense because when you borrow from suppliers, it's typically in smaller amounts, and they are paid back faster, while the loans are for a longer time and at higher amounts.
How a business can leverage debt for growth
There are two major reasons for which businesses take on debt. The first one is to fill a cash flow gap that fundamentally allows them to stay in business through challenging financial times. The second one is using debt financing as a way to stimulate growth. Leveraging debt requires having a clear plan and an understanding of what return on investment you are likely to produce as the funds are invested. Debt is also commonly based on factors such as the equity that an owner has and the perceived value of the company.
In exchange for financing, business owners have to pay the debt back over time. Payments enclose both the principal, meaning the amount that the owner took out the loan for, and the interest, which is essential to determine whether leveraging debt will be profitable or not. The amount of return that you generate, based on how you're investing funds, needs to exceed the interest that you are paying in order for the transaction to make sense. A way to think about all of this is a business term called "EBITDA": Earnings before interest, takes depreciation and amortization.
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Two tips on how to use financial leverage cautiously:
1. Match the type of loan that you are taking with the purpose of your financing:
Let's say for example that you are getting a loan for financing the construction of a building. A building as we all know is a large asset and the normal thing is that it needs more time than other kinds of assets to pay off. So in this case, a long term loan would be the most appropriate one to get. Because a long term loan allows the different contractors to spread out the cost of the different works over time. Like the example, you need to have clear what the financing requires and how much time would it need to be totally paid off.
2. Keep your leverage ratio in check:
Your leverage ratio does a comparison between your liabilities and your assets. Your ratio gives you a solid indication of whether your business is able to meet its financial responsibilities. If you are highly leveraged, this can overburden your cash flow because you will have to make monthly payments on those debts. This can be truly a challenge if your business operation doesn't go as you might have planned, and you don't generate enough income. An expert can always help you out on a regular basis to see if your ratio is in line for operations.
Leveraging can seem a little complicated to understand at first, but it is clearly a very useful way to help your business grow and with no doubt, one of the best ways for speeding up the growth in your business is to make a correct and organized use of financial leverage. Your lender can partner with you to make sure you are contemplating all the risks and choosing the right loans for your business and its projects.
We know finding a perfect leverage for your business is not an easy task, therefore Ameriquest is here to help find a tailored option for their specific business' needs. We are a partner you can count on to help you achieve any project you dream of. Our mission is to provide small businesses with a wide range of financing products that allow them to raise funds more efficiently to complete their projects. We look forward to participating in the creation of a sustainable future for your business.