Using someone else’s money to make you money. That’s the dream, right? The appropriate use of financial leverage (aka operating leverage) in your business can mean the ability to purchase additional assets and jumpstart your business.
Be wary of the risks associated with this strategy, though, as the imprudent use of debt can be extremely costly, turning the dream into a nightmare.
I’ll run through what leverage is and when to use it, as well as some strategies for maximizing and optimizing your available capital.
What is Financial Leverage?
Financial leverage refers to the use of borrowed money (long-term debt) to finance the purchase of assets with the expectation that the net income or capital gain from the new asset will exceed the cost of borrowing.
In other words, it's a strategy that companies use to increase their assets, cash flows, and returns, though it can also amplify losses. If you’re familiar with investing, debt leverage is similar to the use of derivatives; you can do more with less (if done right) and lose money you don’t have (if done wrong).
It's often measured using the debt-to-equity ratio or other financial ratios that assess the balance of debt and equity in a company's capital structure.
When to Use Financial Leverage
Financial leverage should be used under the following circumstances:
- Low Interest Rates: When interest rates are low, it can be fairly cheap for companies to borrow money rather than using their own cash or equity to finance investments. This, in turn, can increase the return on equity for stockholders (and prevent further dilution).
- Stable Cash Flows: Companies with stable and predictable cash flows are better positioned to handle the regular interest payments that come with debt. These companies can use leverage to invest in new projects without risking their operational stability.
- Growth Opportunities: If a company has a high-potential investment opportunity, it might use debt to finance the investment. The expectation is that the returns from the investment will exceed the cost of the debt.
- Asset-Backed Financing: In situations where assets can be used as collateral, companies might opt for debt financing. This can reduce the financial risk for lenders and potentially secure more favorable loan terms for the borrower.
There are times to use debt and times to use equity as a business looking for new capital. These are some of the primary benefits of debt financing:
- Maintain Ownership: Unlike equity financing, where shares/common stock of a company are sold to raise funds, debt financing allows the original owners to maintain full control and ownership of the business. They are obligated to repay the loan amount with interest but do not have to share profits or the business itself with lenders. If you’re anticipating outsized returns for owners, debt is definitely the preferred option.
- Tax Benefits: Interest expenses on debt are tax-deductible. This means the effective cost of the debt is reduced by tax savings, contributing to debt being a cheaper form of financing.
- Cheaper Cost of Capital: Given the low-risk nature of debt financing for lenders, the expected return from investors is typically lower on debt investments than equity investments, meaning debt is often a more fiscally friendly source of financing in the long term.
- Predictable Payments: Debt financing usually involves fixed interest rates and a set repayment schedule. This predictability can help businesses plan their budgets and cash flow more effectively.
- Building Credit: Regularly making loan payments on time can help a business build its credit rating. A good credit rating can be beneficial for securing future financing.
However, debt financing naturally comes with its own drawbacks:
- Repayment Obligation: Regardless of how well the business is doing, the loan and interest must be repaid. This can put a strain on the business, particularly if it is not generating enough cash flow. There are options, though. You can look into revenue-based financing if you’re interested in debt payments that scale up or down depending on your monthly earnings.
- Risk of Over-leveraging: While debt can boost returns, it can also amplify losses. If a business takes on too much debt, resulting in a high leverage ratio, then is unable to meet its repayment obligations, it could face financial distress or even bankruptcy.
- Collateral: Loans often require collateral. If the business fails to repay the loan, the lender may seize the collateral, which could be critical assets of the business.
Equity financing, which involves selling a portion of your business to investors in exchange for capital, has several advantages:
- No Repayment Obligation: Unlike debt financing, equity financing does not require regular repayments. This can be particularly beneficial for startups and other businesses that may not have steady cash flows in their early stages.
- Access to Expertise and Networks: Equity investors often bring more than just money. They can also offer valuable industry expertise, strategic guidance, and connections that can help the business grow.
- Risk Sharing: Because equity investors become part-owners of the business, they share in the risks of the business. If the business does not perform well, the investors bear a part of the loss.
- Long-Term Growth Capital: Equity financing can provide a substantial amount of capital for businesses looking to invest in long-term growth. Since there's no obligation to repay investors in the short term, businesses can focus on using the funds to expand.
However, equity financing also has its drawbacks:
- Dilution of Ownership: By selling a portion of the business to investors, the original owners will have their ownership stake diluted. This means they may have less control over the business.
- Finding Investors: It can be a long, difficult road to get investors, taking up a lot of your time and energy. While there are a number of tips to make it easier, it’s never going to be easy.
- Dividend Expectations: While not a fixed obligation like debt repayments, equity investors sometimes expect to receive dividends as a return on their investment. These dividends typically come at a higher cost than the interest payments on debt financing, which can be a drain on the company's cash resources.
- Exit Strategy: Equity investors typically look for an exit strategy where they can sell their shares for a profit. This could end up creating pressure to do a public offering or a sale of the company, which may not align with the original owners' plans for the business.
If you want to explore equity financing, we have a list of the VCs and angels investing in SaaS businesses in 2023, which includes industries of interest, check sizes, and more.
Maximizing your Financial Leverage
Maximizing financial leverage involves strategically using debt to increase the potential return on investment while maintaining a strong financial leverage ratio. Here are some strategies to effectively maximize financial leverage:
- Optimize Debt Structure: Not all debt is created equal. Long-term, fixed-rate debt can provide stability and predictability in your financial planning. Short-term, variable-rate debt may offer lower initial rates but can lead to higher costs if interest rates rise (which I’m sure we’re all familiar with by now). Balancing different types of debt can help you maximize your financial leverage.
- Use Debt for Income-Producing Assets: The key to successful leverage is using borrowed funds to invest in assets that will generate a higher return than the cost of the debt. This could be an investment in your business, real estate, or other income-producing assets.
- Maintain a Strong Credit Profile: A strong credit profile can help you secure better terms on your debt, such as lower interest rates and more favorable repayment schedules. This can be achieved by consistently making timely payments, maintaining a low credit utilization ratio, and regularly monitoring your credit report for errors.
- Ensuring Adequate Cash Reserves: Ensure that your cash reserve can cover any obligations/liabilities spawning from your financing strategy. Ensuring that you have enough cash reserves and cash flows to cover your financial obligations (including all variable and fixed costs) even if your investments don't perform as expected.
- Regularly Review Your Leverage Strategy: Market conditions, interest rates, market trends, and your financial situation can change over time. Regularly reviewing your leverage strategy can help you adjust your debt levels to maximize your financial leverage.
Measuring Your Leverage
Financial leverage can be measured using several financial ratios that assess the balance of debt-to-equity in a company's capital structure. Here are some of the most commonly used ratios:
- Debt to Asset Ratio: This ratio measures the proportion of a company's assets that are financed by debt. It's calculated by dividing total debt by total assets. A higher ratio indicates a higher degree of financial leverage.
- Debt to Equity Ratio: This ratio compares a company's total debt to its shareholders' equity. It's calculated by dividing total debt by total shareholders' equity. A higher ratio suggests that a company has been aggressive in financing its growth with debt, which can result in volatile earnings.
- Equity to Asset Ratio: This is the inverse of the debt-to-asset ratio. It measures the proportion of a company's assets financed by equity. It's calculated by dividing total equity by total assets. A lower ratio indicates a higher degree of financial leverage.
- Times Interest Earned Ratio (Interest Coverage Ratio): This ratio measures a company's ability to meet its debt obligations. It's calculated by dividing earnings before interest and taxes (EBIT) by interest expenses. A lower ratio can indicate a higher risk of default, as the company may have difficulty covering its interest payments.
- Fixed Charge Coverage Ratio: This ratio is similar to the Times Interest Earned ratio but also includes other fixed charges, such as lease payments. It's calculated by dividing (EBIT plus lease payments) by (interest expenses plus lease payments). A lower ratio indicates a higher risk of default.
- Other Ratios: There are dozens of other ratios not covered above that can be utilized depending on the business and the measures of success within that business. These include, but are not limited to:
- Quick Ratio: Also known as the acid test ratio, this is measured by dividing your most liquid assets (cash, cash equivalents, and marketable securities) by interest payments occurring within the next year. This ratio helps to determine your propensity to pay your short-term obligations, were they to come due immediately. Not to be confused with the SaaS quick ratio, which is a revenue measurement figure.
- Debt-to-Capital Ratio: Divide your total debt by the sum of your total debt and total equity. This ratio shows what percentage of your capital structure is funded by debt financing.
- Debt-to-EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization): Divide your total debt by one year's worth of EBITDA. This ratio determines the capability of the firm to pay off its full debt obligation with future cash flows.
How You Can Optimize Financial Leverage for Your Business
The optimal level of financial leverage depends on several factors:
- Risk Tolerance: Higher financial leverage means higher risk. If your investments don't generate the expected returns, you could face significant losses. Therefore, your level of financial leverage should align with your risk tolerance.
- Cash Flow Stability: If your cash flows are stable and predictable, you may be able to handle a higher level of debt. On the other hand, if your cash flows are uncertain, it might be safer to limit your financial leverage.
- Interest Rates: The cost of debt is a key factor in determining the optimal level of financial leverage. If interest rates are low, it might be cheaper to finance your investments with debt rather than equity.
- Growth Opportunities: If you have high-return investment opportunities, it might make sense to use more financial leverage to take advantage of these opportunities.
- Industry Norms: The optimal level of financial leverage can also depend on industry norms. Some industries, like real estate and utilities, typically have higher levels of debt because they have stable cash flows and large capital expenditures (which can often be used as collateral to lower interest rates). Other industries, like technology, might have lower levels of debt.
The best way to optimize the financial leverage of your business would be to:
- Analyze the market conditions
- What are the current interest rates?
- What are the norms of the industry you operate in?
- Analyze your internal business
- Do you have the cash flow stability to fund debt financing?
- How much debt do you currently carry within the business?
- Assess your internal strategy
- What would we be using this financing for
- What is our willingness to take risks?
At the end of the day, while you’d most likely be celebrated for making additional income for the business, you’d absolutely get canned for taking unnecessary risks with the business’ cash and debt. Use it wisely and take smart risks.
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