Financial Leverage,Or: How I Learned to Stop Worrying and Love the Loan.
This article is part 2 in the Banker Speak series on how entrepreneurs can get the most out of lending.
“I see borrowing as a necessary evil.” – Anonymous (everyone)
“Give me a place to stand and with a lever I will move the whole world.” – Archimedes
Levers are all around us (scissors, crowbars, your arms) and we all enjoy the ease levers bring to everyday life, but for some reason when this time and effort saving simple machine is applied to finance it gets a bad rap. The goal of this article is to paint financial leverage in the same functional light as a tool used to save time and energy like a crowbar used pull out a nail. After all, financial leverage is merely a tool, but just like a crowbar when used improperly it can be fatal. But first an illustration.
My family and I recently went to the circus and our favorite part was the acrobats. At one part in the show they used a seesaw to launch themselves into the air. This circus feat is a perfect example of a physical and a financial lever. To put this tight-clothed circus show into physics (math) terms (and not kill all the fun), the platform – consisting of a length X + L – rests on a fulcrum (red triangle) at a point between X & L and is used to move an object with weight (W) using a force (F). The formula is F=(W*X)/L. Moving more W with less F works well for acrobats and in business the outcomes can be even more impressive.
When a company borrows money it is essentially multiplying (levering) its efforts to get a bigger overall return than it would if limited to only using its own cash (equity). Financial leverage is obtained in much the same way as physical leverage as shown with merely a change in names of the pieces. F = Effort of the organization (all employees using the assets) puts into operating the business. X = Equity, L = Liabilities (we will just refer to this as L for Loan). The Platform = X+L is what is used to multiply the business’s efforts, and the ratio X/L = Equity / Liabilities = Leverage Ratio. W = Net Income and the ratio Equity / Income = ROE is an efficiency ratio that measures how much money the organization is making with the resources at management’s disposal.
Special note: In the financial leverage example, the best description of the fulcrum (red triangle) is the company’s ability to repay debt (a concept covered in the previous article Banker Speak 101). However, in physics many levers have a zero fulcrum (like a hammer) so the fulcrum only matters in relation to a single point that separates X & L.
Putting this all into motion, a company’s effort F is levered (multiplied) using its equity X and will equate to more money W the larger the loan L. The size of L is governed by the size of its equity X and its ability to repay (fulcrum). For the business, leverage means facilitating growth at a rate that would otherwise be unattainable if the platform were only as long as the company’s equity X. For example, a company could use a loan (leverage) to buy a new machine now as opposed to paying cash in 3 years, thus benefiting from 3 years of increased revenue with less effort.
Leverage is fantastic at multiplying returns when times are good, but if there is a slowdown too much leverage can kill all the fun. Just like safety is important with a seesaw, financial leverage can get the business into trouble and prudence must be exercised. Banks generally like to see leverage ratios < 3x for most industries. Experience has shown them that this ratio of debt to equity is manageable in good times and bad. Any higher than 3x and Banks get justifiably nervous.
As one can see, physical leverage and financial leverage are both functional tools. Borrowing money to buy equipment or using a crowbar to remove a nail is merely a matter of improving efficiency by reducing effort required. As for those wanting to move the world, where to stand is still the main issue not to mention where to borrow a stick that big.
This article was written by Austin Werner, a Texas-based finance guy who fancies himself a humorist.
The novel “Predators Ball” by Connie Burk is a great read and an exciting look into the high-flying Leveraged Buy-Out circus of the 80s with the infamous Michael Milken as the ringmaster and a young Carl Icahn as a one of the gymnasts using financial seesaws to launch himself to dizzying heights.