The concept of financial leverage is one of the most important for business owners to understand. When used correctly, financial leverage allows companies to earn profits above and beyond their natural limits.
When people discuss financial leverage, they really mean using debt to acquire additional financial capital. Of course, the simple act of borrowing money does not create extra profits. Instead, borrowed funds need to be put to use such that your business profits increase beyond where they would have been without the loan.
How and Why Financial Leverage Works
The reason financial leverage can work is because creditors, unlike equity investors or owners, do not receive a claim against business profits. Creditors can only receive back the principal plus interest on their loan, no matter how much extra profit you may be able to generate.
For example, you may invest $100,000 worth of capital in your business, and your lenders agree to chip in 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 could only dedicate $100,000 to acquiring assets, creating products or services, and expanding operations. After the loan, the business instantly has $150,000 at its disposal. You are now able to boost potential output without having to reduce your ownership share.
If you want to use 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
The only way to gain from the use of financial leverage is to make more money than you borrowed, plus the interest on the debt. Acquiring financial leverage is not the goal. If you want to maximize profits with financial leverage, the key is to only borrow money that you believe will lead to increases in earnings beyond the full cost of the loan.
Put more technically, your additional EBIT, or earnings before interest and taxes, 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 one-third of the total capital base of $150,000 was acquired through financial leverage, your company must generate at least enough income so that one-third of the income is greater than the interest expense on the $50,000 in debt.
Suppose the 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.
Risks of Financial Leverage
Debt has to be paid back before you can get advanced profits out of your business. In the event that your loan payments exceed the additional EBIT generated by the loan, your company will realize a financial leverage loss.
Borrow too much money and you run the 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.