In simple terms, leverage is the measure of debt (borrowed dollars) to equity (dollars the owners have invested in the business) in your feed and grain firm. When we say that a firm is “highly leveraged,” it means that the company has a large amount of debt relative to how much equity the owners have in the firm. Why is this important? Well, as we discuss in more detail below — if you can use someone else’s money to make you money — you can significantly increase your return on investment. However — we will lay out the disclaimer here — this approach is not without risk! It works great if your business is profitable and you can service this debt. But incurring debt has real costs, and dollars paid in interest are an expense that some owners and managers like to avoid.
Leverage — What is it?
As we mention above — financial leverage is a general term for any technique used to multiply gains (and unfortunately losses, if they occur). A company may leverage its equity by borrowing money. The more it borrows, the less equity capital it needs, so profits are shared among a smaller base and are proportionally larger relative to base equity as a result. We walk through an example via a template later in this column.
Raising capital in your feed or grain business can be achieved via three methods: investors or owners provide the funds (owner’s equity); it can be borrowed (debt) — typically from a lender (bank, etc.); or it can come from business profits (retained earnings).
Debt financing means borrowing money that is to be repaid over a period of time, usually with interest. Debt financing can be either short-term (full repayment due in less than one year) or long-term (repayment due over more than one year). The lender does not gain an ownership interest in your business and your obligations are limited to repaying the loan. In smaller businesses, personal guarantees are likely to be required on most debt instruments; thus in these cases commercial debt financing thereby becomes synonymous with personal debt financing.
Equity financing describes an exchange of money for a share of business ownership. This form of financing allows the company to obtain funds without incurring debt; in other words, without having to repay a specific amount of money at any particular time. The major disadvantage to equity financing is the dilution of your ownership interests and the possible loss of control that may accompany sharing ownership with additional investors.
Debt and equity financing provide different opportunities for raising funds, and a commercially acceptable ratio between debt and equity financing should be maintained. Excessive debt financing may impair your credit rating and your ability to raise more money in the future. If you have too much debt, your business may be considered overextended and risky and an unsafe investment. In addition, you may be unable to weather unanticipated business downturns, credit shortages or an interest rate increase if you have a floating interest rate on your loan. Too little equity may suggest the owners are not committed to their own business. Conversely, too much equity financing can indicate that you are not making the most productive use of your capital as capital is not being used advantageously as leverage for obtaining cash to grow the business.
Lenders will consider your debt-to-equity ratio in assessing whether your business is being operated in a sensible, creditworthy manner. Generally speaking, a local community bank will consider an acceptable debt-to-equity ratio to be between 1:2 and 1:1 (we give additional ranges below).
Obtaining money to use in the business through debt financing does not entail “selling” your equity, but instead works by “borrowing” against it. Debt financing is only available to the business that has something of value that the lender could liquidate if necessary. The bank or other lender is not interested in becoming a partner in your elevator or feed store, instead they are in business to make money from their money by letting you use it for a period of time and then collecting interest on the funds loaned.