Leverage Management
When it comes to leverage, family businesses tend toward two extremes of the financing spectrum. Either they use virtually no debt, paying all cash for assets, or, conversely, they finance 100% of their purchases using no cash! Neither extreme, however, is good management.
Leverage is defined as the percentage of a company’s assets supported by debt. (The easiest and most common measure of leverage is total liabilities divided by total assets.) Using leverage increases a company’s return on equity (ROE) defined as after tax profit as a percentage of owner’s equity. The price owners pay for leverage, however, is a decrease in earnings.
Table I shows the effect of leverage on both earnings and ROE for a bulk plant project with a cost of $1,000,000. If a company’s only concern were earnings, then leverage could clearly be detrimental to its bottom line evidenced by this company’s earnings dropping from $125,000 to $35,000 as debt increased.
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Table I – Leverage and Return on Equity |
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| 0% | 50% | 75% | 90% | |
| Total Assets | $1,000,000 | $1,000,000 | $1,000,000 | $1,000,000 |
| Debt | 0 | $500,000 | $750,000 | $900,000 |
| Stockholder’s Equity | $1,000,000 | $500,000 | $250,000 | $100,000 |
| Earnings Before Interest Costs | $125,000 | $125,000 | $125,000 | $125,000 |
| Interest on Debt (10%) | $0 | $50,000 | $75,000 | $90,000 |
| Net Earnings | $125,000 | $75,000 | $50,000 | $35,000 |
| Return on Equity (ROE) | 12.5% | 15% | 20% | 35% |
Conversely, if return on investment is considered, leverage can improve a company’s return on equity, demonstrated by our example where ROE increases from 12.5% to 35%.
The one major deterrent to leverage is risk. What happens if sales fall off or interest rates spike up? Can a company be harmed by too much leverage? Absolutely! The trick is to find a balance between leverage, risk and return.
Table II on the next page shows an interesting example of a company that is considering leverage for a new store. The owner is uncertain of the volumes the new store will generate. Therefore, he has prepared projections with three sales volumes: $500,000 per year in case the store gets off to a slow start; $1,000,000 per year which he feels is a “do-able” number; and $2,000,000 per year, his target sales goal.
The owner has carefully estimated his costs and determined the estimated earnings before interest and taxes. At $500,000 sales, he will just break even. At $1,000,000 sales, the store will earn $50,000. At $2,000,000, the store will earn the full $125,000 shown in Table I. In each sales volume case, the store could be financed with the same percentages of debt financing we show in Table 1 — 0%, 50%, 75% and 90%.
With this type of information, the owner can make an informed decision about the amount of risk he is willing to accept. With no financing, his ROE will range from 0% to 12.5%. At the other end of the spectrum, he can finance the project with a 90% SBA loan and stand to lose 90% of his investment if sales are slow or to earn a 35% return if things go extremely well. The question becomes; Is he willing to take this amount of risk to boost his return from 12.5% to 35%?
To benefit from leverage, an owner’s return on the asset must exceed the cost of the leverage. In this case, we’ve used a cost of 10%. To justify leverage, the project must return more than 10% before interest and taxes.
| Table II – Leverage, Risk, and Return | |||
| $500,000 Sales | $1,000,000 Sales | $2,000,000 Sales | |
| Zero Leverage | |||
| Earnings | $0 | $50,000 | $125,000 |
| Interest Expense | $0 | $0 | $0 |
| Net Earnings | $0 | $50,000 | $125,000 |
| Return On Equity | 0% | 5% | 12.5% |
| 50% Leverage | |||
| Earnings | $0 | $50,000 | $125,000 |
| Interest Expense | $50,000 | $50,000 | $50,000 |
| Net Earnings | <$50,000> | $0 | $75,000 |
| Return On Equity | <10%> | 0% | 15% |
| 75% Leverage | |||
| Earnings | $0 | $50,000 | $125,000 |
| Interest Expense | $75,000 | $75,000 | $75,000 |
| Net Earnings | <$75,000> | <$25,000> | $50,000 |
| Return On Equity | <30%> | <10%> | 20% |
| 90% Leverage | |||
| Earnings | $0 | $50,000 | $125,000 |
| Interest Expense | $90,000 | $90,000 | $90,000 |
| Net Earnings | <$90,000> | <$40,000> | $35,000 |
| Return On Equity | <90%> | <40%> | 35% |
For typical companies, the amount of leverage that works best for most projects is 75%. Only highly profitable projects can sustain higher leverage.
When making leverage decisions on your next project, also consider the effect of interest rates. A project that looks attractive with 75% leverage at a 10% interest rate may look less appealing at a 12% rate. In general, the higher the interest rate, the less leverage one should entertain.
Finally, remember that the project earnings must exceed the cost of debt for leverage to be worthwhile.
