Leverage is a concept in both business and investing situations. In business, leverage 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.
Both debt and equity financing (using loans vs. selling shares) to start or grow your business have benefits and drawbacks.
The Meaning of Leverage in Business
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.
Leverage involves using capital (assets), usually cash from loans 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.
How to Measure Leverage - The Debt/Equity Ratio
Before we discuss whether leverage is good or bad, it's important to know how leverage is measured. Accountants and investment analysts measure leverage using a financial tool called the debt-to-equity ratio.
The debt-equity ratio measures the amount of debt a business has compared to the equity (ownership amount) of the owners. The debt-equity ratio is shown on the business balance sheet.
To figure the debt-equity ratio, start with "liabilities," and include short-term debt, the current portion of long-term debt (the part that's due this year), and long-term debt. For example, Example Corporation has liabilities of $350,000.
Then look at the ownership part of the balance sheet, either owner's equity (for a partnership or LLC) or retained earnings (for a corporation). Example Company has $600,000 in equity.
The Debt-to-Equity formula is Total Debt divided by Total Equity. In our example, 350,000/600,000 = .5834 or 58.3%. In other words, debt is 53% of equity.
The lower the ratio, the greater a company's safety. The general rule of thumb is that a debt-to-equity ratio greater than 40 or 50% should be carefully watched.
Look at the debt-to-equity ratio of your business compared with other similar businesses in your industry to see how your business stands with industry averages. This article by the University of Wisconsin-Madison has some sources you can use to measure your company's debt-to-equity ratio and other financial calculations.
Leverage is usually thought of as bank loans, but it can also be other kinds of obligations. For example, you might be able to use trade credit—using vendors as creditors—to leverage your company's credit record by using vendors as a financing mechanism.
Two Ways to Leverage From Borrowing
You can leverage your business using either financial leverage or operating leverage.
Financial leverage is leverage from traditional borrowing from a bank or other lender while operating leverage comes from activities like trade financing and payables.
Is Leverage a Good Thing?
Leverage can be a good thing provided that the business doesn't take on too much debt and is unable to pay it all back.
Operating and financial leverage affect your business differently.One (2003) study showed that
"Leverage from operating liabilities typically levers profitability more than financing leverage and has a higher frequency of favorable effects."
That makes sense because when you borrow from suppliers, it's typically in smaller amounts and paid back faster, while loans are typically for a longer time at higher amounts.
A leveraged buyout is the purchase of a business using borrowed money. The assets of the company being bought are used as collateral for the loans by the buyer. The idea is that the assets will immediately produce a strong cash flow.