Business loans aren't just used for short term cash management are buying long term assets.
Loans are a critical component of business plans.
Financial leverage which is the use of borrowed money magnifies returns.
Business and Investment gurus tout how you can make big money with little money of your own.
They show how using other people's money can make you rich.
It's true that using other people's money known by the acronym OPM can increase your returns.
But OPM can also be like the drug OPM its highs come with crashing lows borrowing large amounts of money
increases the risk your business may run out of cash or have big losses in a downturn.
I'll explain how this works and how to reduce your risk.
I'm going to go through a formula and a couple definitions but don't freak out if you don't quite follow
all this.
I'll show some examples in later slides.
Even if you don't fully understand the numbers I want you to understand the concept that debt magnifies
both returns and risk return on equity as how much the owners earn on their investment in the company
return on assets is income divided by the assets of the company.
It's a way of measuring how profitable the assets are.
Those two returns are related.
Return on equity is equal to return on assets.
Times leverage.
So that first Formula leads us to ask what's leverage and how do you measure it.
Leverage refers to how much debt you have in the ROV equation.
Leverage is measured as one plus the debt to equity ratio.
OK so what's the debt to equity ratio.
It's your debt divided by your equity.
In other words it's how much you've borrowed divided by the accounting value of your company.
A ratio of one where debt and equity are both equal means the company has borrowed as much as the owner's
accounting value in the company borrowing more debt causes the debt to equity ratio to go up.
Like I said your head may be swimming a little from the formulas.
Here's an important concept from the formula.
Leverage by itself doesn't increase your return on equity but it does magnify it.
Here's another way of saying this borrowing money doesn't increase the return to the owners but it magnifies
it.
So what do I mean.
It magnifies return on equity.
If your return on assets is highly positive borrowing money usually makes the return to the owners the
ROV go up.
However if the return on assets is negative borrowing money will make the return to owners to become
much more negative.
I'll show two examples to explain this more let's look at how leveraging a company magnifies its return
on equity.
In this example the company has one million dollars in assets.
They have a few miscellaneous liabilities like accounts payable but no business loans.
Their debt to equity is a very low point one 1.
Their profit is one hundred thousand dollars so they have a return on assets are a way of 10 percent
and a return on equity or ROIC of eleven point one percent the owners then decide to get bank loans
to invest in company assets to magnify the return on equity.
This is the second column.
They borrow two million dollars so the total assets are now three million dollars.
For simplicity let's assume they still earn 10 percent on their assets before interest costs.
Their profit before interest expense is three hundred thousand dollars.
Assume the loan has a 7 percent interest rate.
They would pay one hundred and forty thousand dollars of interest expense.
So their net income is one hundred and sixty thousand dollars.
Their return on assets decreased from 10 percent to 5 percent because they now have to pay interest
on the cash they got to fund the additional assets.
However the return on equity has jumped from eleven point one percent to seventeen point eight percent.
In other words leverage cut their archway in half but increase their ROIC by 60 percent.
The owners are making a lot more money.
What could go wrong
once again.
Leverage doesn't increase ROIC it magnifies it.
Many business owners hear about how leveraging using other people's money can make them rich.
That assumes a decent on leveraged are a way a lower negative archway can cause massive negative ROV
and cash outflows.
The dark side of leverage is shown in this example.
Our sample company is now earning a small loss.
The first column shows their results with no leverage.
They have an hour away of negative 1 percent and an army of negative 1 percent.
Their net loss is ten thousand dollars which is probably fairly manageable with one million dollars
in assets and nine hundred thousand dollars in equity.
Now look at the leverage column they have three times as many assets so their lost before interest is
three times larger.
A thirty thousand dollar loss may not hurt them too badly but they also a one hundred and forty thousand
dollars in interest.
There are way after leverage is minus 6 percent and there are we as a negative 19 percent.
To summarize a small negative way an ROV with no leverage has been magnified into a massive negative
ROV through leverage.
There are we with leverage is 17 times lower than without leverage.
The biggest problem isn't earnings.
It's cash flow.
Companies fail from lack of cash flow not lack of earnings.
Most owners plow the full two million dollars of borrowed money into non liquid assets like real estate
or equipment non liquid assets or assets that cannot be easily sold or otherwise turned in the cash
they may have even used some of their cash when they had only one million dollar in assets as their
down payment or equity portion of those illiquid assets.
They may have nowhere near the cash left to service a one hundred and seventy thousand dollar loss as
a banker.
I saw this happen with many business owners during the Great Recession.
Real estate investors and owners who made big expansions before the downturn were caught with little
cash and big payments.
To put this all together you must balance both profit and risk when deciding how much to borrow and
how to use the cash from that borrowing.
Borrowing funds to increase your investments and grow your company can cause the return to owners to
greatly increase.
On the other hand the return to owners is decimated.
If the investments start earning low or negative returns.
More importantly than earnings is cash flow.
When you have decent income from investments it's not hard to cover your loan payments.
You will need to have a good reserve of cash available for your loan payments when earnings falter though.
I encourage you to keep a larger reserve of cash as your borrowing increases the increased borrowing
increases both your profits and your risk over the long term.
The cash reserve will allow you to keep most of the profits and reduce your risk using leverage and
keeping reserves mean you will receive higher returns during the good times while covering your loan
payments and losses during the rough times.