When you hear people discuss financial leverage, they really mean using debt to acquire additional financial capital. Financial leverage allows companies to earn profits above and beyond their natural limits. Of course, the simple act of borrowing money doesn’t create extra profits. Instead, you need to put borrowed funds to use in a way that increases your business profits beyond where they would have been without the loan.
How and Why Financial Leverage Works
The reason financial leverage can work well for increasing your profits is because creditors, unlike equity investors or owners, don’t receive a claim against business profits. Creditors only receive back the principal plus interest on their loan, no matter how much extra profit you generate using the borrowed funds.
Say you invest $100,000 worth of capital into your business, and your lenders agree to provide another 50%, or $50,000 in this case. This is an example of using owner’s equity as the basis for your loan. Before the loan, your company only has $100,000 to put toward acquiring assets, creating products or services, and expanding operations. After the loan, you have $150,000 at your disposal. You’re now able to boost potential output without having to reduce your ownership share. Using a mechanical analogy, your equity investment acts like the support and your $50,000 loan is the lever that lifts the total capital base of your business.
Using Leverage Properly in Your Small Business
To maximize leverage and make a gain, you need to make more money than you borrow plus the interest on the debt. Acquiring financial leverage isn’t the goal. If you want to maximize profits with financial leverage, the key is to only borrow money that you believe can lead to increases in earnings beyond the full cost of the loan.
Put more technically, your additional earnings before interest and taxes (EBIT) must be larger than the principal and interest on the business loan. Go back to the example with $100,000 in owner’s equity and $50,000 in debt. Since your company acquires one-third of the total capital base of $150,000 through financial leverage, you need to generate at least enough income so that one-third of the income is greater than the interest expense on the $50,000 in debt. If the principal and interest expense on the year is $2,500, your business needs to generate more than $7,500 in EBIT to realize a financial leverage gain.
When you use financial leverage, you have to pay back the debt before you can get advanced profits out of your business. If your loan payments exceed the additional EBIT generated by the loan, your company sees a financial leverage loss. Borrowing too much money can put you at risk of bankruptcy. This is why investors tend to like corporations that use financial leverage, but only to a point. The more debt your business accumulates, the harder it is to generate enough extra returns to pay it back profitably.
Understanding how to successfully use financial leverage can help your company get ahead financially. Tools to help you track those financial decisions makes it easier to maximize your profits. Using an accounting system, such as QuickBooks Online, you can generate a Profit and Loss statement automatically. Learn how today.