How Leverage Can Benefit Your Business
Using Leverage to Support Business Startup and Growth
Leverage is a business term that refers to how a business acquires new assets for startup or expansion. It can be used as a noun, as in, "Leverage is a way to allow a business to expand...." or it can be a verb, as in, "Businesses leverage themselves by getting loans for expansion."
When a business is "leveraged," it means that the business has borrowed money to finance the purchase of assets. Businesses can also use leverage through equity, by raising money from investors.
Where the Term Comes From
The concept of leverage in business is related to a principle in physics where it refers to the use of a lever that gives the user a mechanical advantage in moving or lifting objects. Without leverage, such a task might not be accomplished.
Businesses can use leverage to fund company growth and development in a similar way, through the purchase of assets. Such growth could not be accomplished without the benefit of additional funds gained through leverage.
How Leverage Works—An Example
A small retailer wants to expand into an available space next door in a strip mall. In addition to increased rent, the business will have to buy fixtures, shelves, tables, and other operational necessities. It will also require additional inventory.
Most small businesses don't have sufficient cash on hand to cover all these expenditures, so the retailer applies for a business loan. This loan is leverage. It allows the business to do what it couldn't do without the additional funds.
Is Leverage a Good Thing?
Leverage can be a good thing provided that the business doesn't take on too much debt and it's unable to pay it all back. A lender typically looks at the amount of debt leverage a business already has when considering whether a business loan application should be approved. How much more debt can the business reasonably afford to take on?
Leverage As a Business Measurement Tool
One way to look at the amount of leverage in a business is to calculate its debt to equity ratio. This shows how much of the business's assets are financed by debt and how much by equity or ownership.
Rosemary Peavler at Business Finances says:
"In general, if the company is in debt more than 40 to 50 percent, the company should look at its financial statements more carefully and compare itself to other companies in the industry. It might be in financial difficulty."
Trade credit—using vendors as creditors—can be a way to leverage your company's credit record by using vendors as a financing mechanism.
Equity as Leverage
Although business debt is most often used as leverage, businesses sometimes use equity financing as well. In this case, a corporation's board of directors might approve a stock offering, encouraging new investors and using their investment as leverage for business growth.
Another example is capitalizing on existing nontangible assets such as reputation to raise money, such as through franchising. A restaurant might license its brand or a renowned recipe for retail sales or for use by catering services.
A leveraged buyout results in a business's assets being absorbed by another, generally smaller, company through financing with little capital down. The idea is that the assets will immediately produce a strong cash flow. Of course, the result can be disastrous if this doesn't occur.