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.
Leverage - How is it measured?
There are a number of measures of leverage. Perhaps the easiest and most often cited measure is the debt to equity (D/E) ratio. It indicates the relative proportion of owner’s equity and debt used to finance a firm’s assets. The two numbers needed are taken straight from your feed company or grain elevator’s balance sheet and are calculated as:
Debt/Equity = Debt to Equity ratio where:
Debt = all of the liabilities (short-term and long-term) the business has
Equity = Shareowner’s or Owner’s Equity (also known as Net Worth)
Examples:
Grain Elevator A:
Debt = $972,000
Equity = $1,000,023
D/E ratio = 972,000/1,000,023 = 0.972 or 0.972:1 almost a 1:1 ratio
Grain Elevator B:
Debt = $2,347,054
Equity = $1,096,578
D/E ratio = 2,347,054/1,096,578 = 2.14:1 or over a 2:1 ratio
In the above examples, Grain Elevator A is equally financed between debt and equity, while Grain Elevator B has twice as much debt as equity and is much more “highly leveraged.”
On your balance sheet, the formal definition is that debt plus equity equals assets, or as one of us states in our university Agribusiness Management class — “your firm’s assets are jointly owned — either by you (equity) or the bank (debt).” Financial leverage ratios provide an indication of the long-term solvency of the business. Unlike liquidity ratios – which are concerned with short-term assets and liabilities — financial leverage ratios measure the extent to which the company is using long-term debt. In addition to the D/E ratio discussed above, another measure is the debt to capital ratio, defined as total debt divided by total assets:
Debt ratio = Total Debt/Total Assets
This measure tells whether a company is more prone to using debt financing or equity financing. Using the same numbers from our example above:
Grain Elevator A:
Debt = $972,000
Assets = (Debt + Equity) = $972,000 + $1,000,023 = 1,972,023
Debt ratio = 972,000/1,972,023 = 0.49
Grain Elevator B:
Debt = $2,347,054
Assets = (Debt + Equity) = 2,347,054 + 1,096,578 = 3,443,632
Debt ratio = 2,347,054/3,443,632 = 0.68
In these examples, Grain Elevator B is utilizing more debt financing, as 68 percent of their total assets is comprised of debt.
Leverage – Guidelines and Ranges
The range of what can be considered a “normal” debt-to-equity ratio can vary by industry. Some industries use more operating capital because they need to buy more materials to produce their products or service. Construction companies, for example, must purchase a lot of building materials, and they usually carry the cost of these materials via debt, until the finished product is sold. As a result, the debt-to-equity ratio in this industry can vary from 1.3 to 2.4 on the high end (with higher leverage given by a larger number — and anything over 1 indicating that the lender has a bigger stake in the firm than the owners do). In contrast, a company in the services industry — such as an advertising agency or consulting company — does not have to buy much in the way of materials. These companies rely on their human “capital” and will have a lower D/E ratio, which might be in the 0.65 to 0.8 range. Some average Debt-to-Equity ratios by industry might be: Agriculture: 1.33; Mining: 0.48; Retail Hardware: 1.30; Automobile retailing: 2.61; Restaurants: 1.24. The Debt-to-Equity ratio for cooperative grain elevators in the Pacific Northwest averaged 0.455 in a recent study conducted by Washington State University. As mentioned above — if a firm’s liabilities exceed the firm’s net worth, then creditors have more at stake than the owners, and the firm’s D/E ratio will exceed 1.0
How can you make it work for you?
Borrowed money can be used to increase production volume, and thus sales and earnings. Since interest is a fixed cost (which can be written off against the firm's revenue) a loan allows a firm to generate more earnings without a corresponding increase in equity capital — which for most corporations requires increased dividend payments (which cannot be written off against the earnings).
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 2 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!
Risk
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.
Summary
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.
