Leverage is generally defined as the ability to generate more results with less direct effort. You cannot lift a truck directly to change a tire, so you use a jack to leverage your effort. In your electrical contracting business, leverage is the use of long-term borrowed capital to increase the return on owner equity. Financial leverage measures the effect of interest rates on borrowed debt. Operating leverage analyzes how sensitive profits are to changes in the level of sales revenue (measured as gross profit divided by profit before tax). Total leverage is the product of the two multiplied together.
Americans have been accused of being overleveraged, as the level of borrowing increased while savings decreased. This oversimplification fails to consider the difference between borrowing to finance an asset (such as a home) that contributes to personal net worth, and borrowing money to go on a vacation, which does not.
The same is true for your electrical contracting business. Using other people’s money for asset purchases, instead of reinvesting your own profit, increases the return on owner investment, if you know how leverage works. For example, it has the greatest impact at your break-even point, so it is riskiest when you are just scraping by. It also creates new fixed costs (interest) and a degree of risk related to the interest rate and terms of the lending agreement.
Leverage multiplies a small increase in revenue to create a larger return on equity but also multiplies the negative effect of a small reduction in sales. So, during a downturn, it increases risk, but it also creates greater benefits during the good times. It can be used to fund both working capital and fixed assets. Receivables or inventory often collateralize the former, while the latter is used as collateral for a loan based on its useful life span.
The most common measure of leverage is the debt-to-equity ratio, calculated by taking the long-term debt from the balance sheet and dividing it by owner equity. If you have long-term debt of $2 million, and shareholder equity of $4 million, for example, your ratio is 1-to-2, equivalent to the fraction. As long as the numerator is equal to or less than the denominator, you have a reasonable degree of leverage.
Lenders used to accept 2-to-1 routinely, and even higher levels for good customers, but the current lending climate has made them reluctant to own more of your company than you do.
The alternative to other people’s money is equity leverage. You earn a profit, and either distribute the money to shareholders or reinvest it back into the business. The reinvested profit raises the equity total on the balance sheet, and this equity can be used to acquire assets. The problem with “equity financing” is the lack of liquidity; tapping equity might force you to sell assets to generate cash.
Your debt-to-asset ratio (dividing total liabilities by total assets), shows the proportion of the assets financed through leverage, or debt. If you have $1 million in total liabilities and $5 million in total assets, the debt-to-asset ratio is 1-to-5, and you own four-fifths, or 80 percent, of your assets outright. Reverse the numbers and you have the same situation as a homeowner faced with a short sale. Default on your loans, and the creditors will never recover their investment, and probably go after your personal assets.
You might be able to obtain “non-recourse debt,” which lowers the risk of using financial leverage to purchase assets by allowing the creditor only to recover pledged collateral in a default situation. Loan agreements containing personal guarantees are classified as “recourse debt” because the lender can repossess the pledged collateral and also go after your personal holdings. In the present lending climate, you are more likely to be asked for a personal guarantee.
Leveraging assets you already own is one of the least risky ways to borrow. You should consider several factors in making this decision. If your sales revenue is stable, then incurring the fixed cost of interest and repayment is less risky. If sales and earnings are growing by 15–20 percent per year, you should be able to incur interest expenses of 10–12 percent and still show improved earnings per share. Competition also affects leveraging decisions. During a growth phase, ease of entry by new firms may lower margins and profits, making it riskier to carry more debt. Finally, the ratio of long-term debt to short-term debt affects your ability to meet repayment schedules.
Leverage is also defined as the power to produce an effect indirectly, by means of influence or clout. Consider intangible assets such as your reputation in the marketplace, customer relationships, motivation and talent of your employees, and how they might influence your financial stability and profitability—without incurring more debt.
NORBERG-JOHNSON is a former subcontractor and past president of two national construction associations. She may be reached at email@example.com.