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Got a fantastic business opportunity but no cash in your bank account? You need to leverage your assets to gain capital.
Leverage is a tool businesses frequently use to grow inventory, purchase equipment, or grow their assets. And you can use it to finance your next big acquisition—be it a new computer, factory, or venture.
However, while leverage is a great source of funding and can increase the rate of return on equity, it also magnifies risk. A business that lacks sufficient cash flow will be unable to meet interest rates and principal payments. So, you’ll want to understand the types of leverage you have on your balance sheet to evaluate expected risks and returns and avoid losses.
This article explores what leverage is, how it works, and the types of leverage you can choose to increase your potential returns.
What is leverage?
Leverage refers to borrowing funds for a particular purpose with an obligation to repay these funds, with interest, at an agreed-to schedule. The idea behind leverage is to help borrowers achieve a higher return with a smaller investment.
You’ll want to forecast your expenditures and determine your funding requirements before deciding what kind of leverage to use. Instruments like derivatives, where the investment is a small fraction of the underlying position, can be used as leverage. However, in this article, we focus on debt.
How does leverage work?
If and when your business is ready to increase its scale of operations, expand into new markets, or update existing infrastructure, you’re going to need funds. However, if you don’t have enough equity or cash upfront, you’ll have to borrow funds.
Two ways to borrow capital are to issue bonds (equity financing) or borrow directly from lenders (debt financing).
Equity financing involves selling your equity in exchange for funding. One of the biggest benefits of equity financing is that it doesn’t lead to the company having to make interest payments or any principal repayment. Some of the most common examples of equity financing are initial public offerings (IPOs) and crowdfunding.
Debt financing involves a company borrowing money to fund working capital requirements. When a company borrows money, it needs to make interest payments as well as repay the principal. Taking a loan is a common debt financing example.
The 3 main types of leverage
There are three main types of leverage:
- Financial
- Operating
- Combined
We explain each in more detail below.
Financial leverage
Financial leverage refers to the amount of debt a business has acquired. On a balance sheet, financial leverage is represented by the liabilities listed on the right-hand side of the sheet.
Financial leverage lets your business continue to make investments even if you’re short on cash. It’s usually preferred to equity financing, as it lets you raise funds without diluting your ownership.
How to calculate financial leverage
You can determine the degree of financial leverage your business has through the debt-to-equity ratio. This ratio represents the proportion of assets your business has compared to its shareholders’ equity.
The formula is:
Let’s assume your total assets for the current year are $100,000, and for the previous year, they were $90,000. Your average total assets would then be:
(100,000 + 90,000)/2 = $95,000
You can calculate average total equity the same way.
So,
A financial leverage ratio of 1 indicates no leverage. The higher the ratio, the more leveraged your business is and the riskier your capital structure.
Operating leverage
Operating leverage accounts for the fixed operating costs and variable costs of providing goods and services. As fixed assets don’t change with the level of output produced, their costs are constant and must be paid regardless of whether your business is making a profit or experiencing losses. On the other hand, variable costs change depending on the output produced.
You can determine operating leverage by finding the ratio of fixed costs to variable costs. If your business has more fixed expenses than variable expenses, it has high operating leverage. You can use a high degree of operating leverage to magnify your returns, but too much of it can increase your financial risk.
How to calculate operational leverage
As mentioned, operating leverage is the ratio of its fixed costs to its variable costs. You can calculate this using the formula:
Let’s look at the hypothetical accounts for Business A and Business B,
Business A and Business B have a similar income statement structure; the only difference is that Business A has higher fixed costs than Business B. This implies a higher degree of operating leverage for Business A.
Therefore, Business A has higher operating leverage than Business B.
When demand is high and sales increase, profits rise by a more significant percentage for Business A than Business B. The average cost per unit also decreases by a greater amount for Business A than for Business B.
In contrast, when sales stagnate, Business A suffers more than Business B. Profits for Business A decline more than they do for Business B, and the average cost per unit rises for Business A more than it does for Business B.
Operating leverage can be used by businesses that have a large number of fixed assets. For example, capital-intensive companies, such as steel production, car manufacturing, and oil extraction, can leverage their fixed assets to reduce the average cost per unit and increase Earnings Before Interest and Tax (EBIT)
Combined leverage
Combined leverage accounts for your organization’s total business risks. As the name suggests, combined leverage aggregates the effects of operating and financial leverages to present a complete picture of your company’s financial health.
Combined leverage can be used by capital-intensive businesses with expansion potential but insufficient levels of cash or equity. To effectively use combined leverage though, be sure of your business’s future expenses and the market conditions. High levels of combined risk can make returns susceptible to inputs, such as sales volumes.
How to calculate combined leverage
Combined leverage is the sum of operating and financial leverage. You can calculate it using the formula:
Leverage disadvantages
Leverage can magnify returns with a smaller investment, and while many investors prefer it to equity financing, there’s no such thing as a free lunch. Too much financial leverage can drive up a business’s risks, including:
- Insolvency: The more your company uses total debt, the harder it is to pay back. Banks and other institutions often check your total leverage and financial ratios, such as debt-to-equity and interest coverage, before agreeing to lend to you. Having too much total debt could have a risky cost structure, and you could have difficulty raising additional funds.
- Higher interest payments: Long-term debt can eat into a company’s bottom line because interest is paid from income. Also, the riskier your business seems to lenders, the higher your interest expense and resulting cost of capital.
- Liquidation: Your business can lose assets or eventually declare bankruptcy if it repeatedly defaults on payments. Banks and other lenders might seize assets like buildings and machinery if you can’t pay back their loans.
Need help? Hire a freelance financial analyst
Although operating and financial leverage focuses on different aspects of a business, they contribute to additional risk in similar ways. So, you’ll want to ensure fixed and timely payments on all financial obligations!
Unfortunately, staying on top of your financial management and accurately forecasting operating income can be challenging, especially if this isn’t your area of expertise. For additional assistance, we recommend hiring freelance financial analysts through Upwork to help you with all your borrowing needs while ensuring minimal risks.
