As mentioned in our introduction — appropriate use of leverage (debt) can increase return on investment (ROI). Figure 1 shows the step-by-step process of developing an ROI analysis. ROI, as we measure it here, is in terms of return on net worth or owner’s equity. You can plug your numbers into our template and determine your ROI. The point we are making is that higher leverage will increase ROI, as ROI is the product of Return on Assets multiplied by Leverage. The other ways to improve ROI (that do not involve debt) are to improve profitability (net profit %) or to utilize your assets more efficiently (increase asset turns).
Let’s use our two example firms to calculate their return on net worth — and to keep it simple, we will assume that they both have the same net profit, and asset turns — so as to focus on the impact of leverage (disclaimer — yes we know that no two firms in the real world would have identical numbers, but it allows us to focus on the leverage issue). We will use a net profit of 4.1% and asset turns of 3.1, generating a return on assets of 12.71. When this value is then multiplied by the respective firm’s leverage, it generates the following results:
Grain Elevator A:
12.71 x 1.97 = 25.04
Grain Elevator B:
12.71 x 3.14 = 39.91
Thus, Grain Elevator B has a significantly higher return on investment because it is profitable and is more highly leveraged. Please read further to look at the risk side of this equation!
Be aware of risks
Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Heavily leveraged (i.e., debt-financed) companies are constantly undercapitalized and may experience continuing cash flow problems as they grow. Paying close attention to strained cash flow requires that a lot of management time be diverted from company operations. It also affects the balance sheet, making it difficult to obtain additional equity or debt. On the other hand, there is one big positive in using debt. Debt does not decrease or dilute the entrepreneur’s equity position and it provides nice returns on invested capital as we have discussed above. However, if credit costs go up, or sales don’t meet projections, cash flows really get pinched and bankruptcy can become a reality.
While we are not necessarily promoting the use of debt — we are emphasizing that its prudent use is a tool that you as an owner or manager can utilize to grow your business and improve your return on investment. You should seek input from your accountant to assist you in determining the proper level of debt versus equity for your feed mill or elevator.