Introduction
“In the dynamic world of business, the concept of ‘leverage’ plays a pivotal role, often acting as a financial fulcrum that can either propel companies to new heights or lead them into precarious territory.
Leverage is the strategic art of amplifying resources, making the most of available capital, and optimising financial structures. Leverage is a powerful tool that allows businesses to reach further, grow faster, and achieve their goals more efficiently.
In this blog, we will share some thoughts about leverage in business – exploring a simple but straightforward example to understand leverage and how savvy business owners harness its potential to fuel growth and success.
Whether you’re a seasoned business professional or a newcomer to the financial landscape, understanding the nuances of leverage can be a game-changer in your quest for sustainable prosperity and competitive advantage. So, join us as we unravel the mysteries and opportunities of leverage in the corporate world and discover how it shapes the destiny of businesses.
Using Leverage to Amplify Financial Returns
The term ‘leverage’ occurs in finance because of the multiple ‘levers’ present in a business to help it magnify its returns. Understanding how to apply the right financial and operating leverage in the business often helps unlock the business’s real potential.
For a lot less effort than would otherwise be required. An increase in leverage is an increase in risk in the business, and therefore, operating and financial leverage need to be applied in a balanced manner, often setting one off against the other.
If debt is available at a specific interest rate and the business is confident that it can make a higher rate of return, it makes sense to deploy debt to magnify the return. For example, if the RoA is 13.8% and the business can raise debt at 4%, the difference between these two returns would flow directly to the equity holder, the business owner.
When taking debt, it is essential to look at the cash flows available to regularly meet the interest charges and principal repayments on the debt and avoid any defaults or breach of any covenants that a lender may impose. As cash flow is usually not directly presented in the annual accounts of a business, lenders rely on a proxy for cash flow, the earnings before interest, tax, depreciation and amortisation (EBITDA). Usually, an interest cover ratio more significant than three is seen as a sign of a healthy business, whereas a ratio below two is considered a cause for concern. A debt multiple greater than three usually points to the business using too much debt.
About the authors:
Amol Maheshwari is the Managing Partner and M&A head at Growth Idea. Shweta Jhajharia is a leading global business coach and founder of Growth Idea. Their new book Score is the ultimate handbook to help SME business owners and senior leaders master the fundamentals of finance in order to propel them towards unprecedented success.
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