Leverage is valuable in both investments and business. If you need to acquire new assets, you typically need leverage, whether you are working on a startup or experiencing business growth. So, what is leverage, and how can it help you with your business costs?
You have leverage when you have valuable assets because these assets can be leveraged to gain cash through a loan. Therefore, rather than spending your available cash for any startup or expansion costs, you leverage your assets into a loan to finance those expenses. Equity can also be used to borrow money. This borrowed money can then be used to purchase equipment, hire employees, or pay other business expenses.
Two Types of Leverage
Your business has access to two types of leverage: operating and financial leverage. You can leverage your operations through financing your accounts payable to your suppliers. You can also finance your trade activities under operating leverage. Typically, your creditors are your vendors in these cases. However, borrowing from banks or other lenders is considered financial leverage.
Leverage Can Be Measured
The debt-to-equity ratio is used to measure your leverage. This tool measures how much debt you have and compares it to the amount of equity you have. Both of these factors as well as the ratio can be found on your company’s financial statements. This tool calculates your liabilities, including your short-term debt and the amount of your long-term debt that is due within one year. Then, your company’s retained earnings and equity, which are found on your business balance sheet, are calculated. Then, your equity is divided into your debt.
An ideal ratio is 40-50%. This means that you are using your money efficiently.
The Good and the Bad
Leverage allows you to pay business expansion expenses through borrowing rather than spending your available cash, which you may need to pay your regular operating costs, save for emergencies, or spend on greater inventory as you expand. It ensures that your cash flow is not negatively impacted due to your expansion. However, pay close attention to your debt-to-equity ratio to ensure that you aren’t borrowing too much and putting your company in danger.
Some of the best leverage you can have is operational because you are typically borrowing from your suppliers for a short period of time. These debts are also typically much smaller. However, many loans have a minimum, so they tend to be much larger and your payback period is much longer.
Leverage gives your business flexibility to pursue its business growth strategy. Learn more about this tool so you take advantage of the benefits it offers.