Leverage
The Oxford Dictionary provides two (2) definitions of this term. One is what most people think of when they hear the word leverage, the exertion of force, the other is specifically for Finance, the ratio of a company’s loan capital (debt) to the value of its common stock (equity). There is, of course, a third vision that comes to mind which includes Timothy Hutton and the Television Series by the same name. For purposes of this Blog, we will chose the second definition.
The basic premise of a company balance sheet can be defined by Assets = Liabilities + Owner’s Equity. It is one of the first things anyone taking an introductory accounting course will hear and come to memorize. But, there is another formula that all business owners should be acquainted with throughout their firm’s life. It does not require a degree, just an understanding of calculating a fraction, and knowing the appropriate description to place in your numerator and denominator. It is surprising how basic mathematics from grammar school and high school can be used to determine a critical component of financial success in your business.
Even if your firm does not borrow money from a bank or capital source, knowing your firm’s leverage should be included in your annual conversation with your accountant, your finance officer (if you have one), or your business partner(s), if you are not a sole proprietor. Why? Because it is a calculation that will drive any future conversations with your Banker. It also helps you, as an owner, gauge the progress of your firm’s success. And, it may be the single calculation that makes or breaks your ability to grow with conventional borrowed funds. You never know when you may need to borrow funds from a lending source and knowing your leverage, tracking your leverage can be an initial starting point for that discussion.
So, you may wonder, what is an ideal Leverage Ratio? As you might imagine, that can vary, from bank to bank, whether you choose an alternative lending source, and it can be influenced by many factors, applicable only to your industry. As a basic guideline, it has been my experience that a firm’s total debt divided by total equity should be in the zero to 3x - 5x range, before conventional financing seeks to utilize alternative lending. Alternatives may be in the form of government guarantee enhancements, such as an SBA guarantee.
Once your company has more borrowings than contributed equity, the term levered or leveraged is often used in banking and underwriting circles. The degree to which that leverage is acceptable for providing more lending is specific to your bank, whether you qualify for government enhancements like the SBA mentioned above or an IDA (Industrial Development Agency) enhancement. IDAs may often have their own financing group which will buy out or participate with a percentage of the bank’s total lending package. Some banks will exclude secondary forms of government direct financing in their calculation, others will not. So, like anything in life, it does often pay to do your research and ask for more than one quote.
At your next annual meeting with your accountant, spend a few minutes and understand your firm’s leverage ratio. It can be a defining ratio for your future growth plans or just a threshold you want to monitor as your business grows or changes.
Like our Blog Photo this week, in which two (2) Barbet are play wrestling, neither wants to give up his leverage on the other. A goal to have more invested in your company than borrowed should always be near the top of your list!
Be well.
