Financial leverage, or gearing, may be hazardous to your company’s health!
After the target setting and strategic analysis, it is time to select strategies to address the issues emerging from these earlier stages.
Leverage may be a strategic option in some situations where the capital structure of a business has become an issue.
Many people agree, at least in principle, with a saying like “Neither a borrower nor a lender be”. A respected figure such as Benjamin Franklin said, “I’d rather go to bed supper-less than rise in debt”.
Does this always apply in a business context?
Let us clarify what we mean by such leverage before considering it in a corporate business strategy.
Think of leverage or gearing as the relative shares or ratio of borrowed funds to equity capital in the total finances of the business in question.
If your business has $5million of owners or investors’ funds, and borrows an additional $1million from a bank or other provider of debt finance then the leverage is one to five or 20 percent. Sometimes this is unhelpfully given as 1 to 6 or 17%!
It may be more useful to think of leveraging finance simply in terms of the ability of the enterprise to pay off the debt. This means looking at the interest to be paid compared with the funds available to pay it, or what is sometimes called ‘interest cover’. A business with $6million in profits and $2 million in interest payments has an interest cover of three to one.
A company with high leverage and low interest cover is heading into troubled waters, or playing with fire!
How long is a piece of string? With leverage, this is the test. If the company could comfortably cover additional borrowings, it is not too highly geared. If it could not, then it is already too high!
If this is the case, then the corporate strategy, no matter what else it attempts to do, must include an element of debt reduction. With this situation, some other strategic options will clearly be out of the question. Seeking to expand rapidly, introduce big changes in product range, upgrading plants and so on, would be unwise before strengthening the financial structure.
Why look at leveraging as a strategic option?
Despite the common perception that gearing is inherently risky, most individuals and enterprises make use of borrowings at some stage. This is because, if used within prudent limits, borrowing funds can be one of the most powerful ways of driving business growth.
However, there are two conditions necessary for borrowing to become a powerful lever to grow the business. The first is that the borrowing enterprise must be able to make its payments or it risks losing control of the enterprise to the financier who made the loan. The second is that the asset underlying the leverage holds its value. As leverage accentuates the profit when asset values rise, it decimates returns when values fall.
Without these conditions, the party is over, and the benefit of leverage becomes a huge liability.
Most successful businesses have used financial leverage to grow the business.
Additionally, debt, if the funds are used to pay for themselves, is a great way to keep your current cash in the business, as working capital, while growing your operations through such things as financing more cost efficient equipment.
You can really improve your firm's profitability through the proper use of leverage. For example using taking out loans to purchase income-producing assets, or invest in the business. This can return enough profit to more than cover loan repayments. This enables you to keep the cash you do have available for new opportunities that may come along.
It is vital that you do your homework on the likely risks, and borrow well within the risk level you can tolerate and still sleep at night!
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