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A small-business owner needs funds to open the doors and start operations. Funds are needed to buy equipment, hire employees, make deposits for utilities, launch advertising campaigns and serve as operating capital. These funds can come from personal savings invested as equity capital or money borrowed from outside parties, such as banks.

Each source of funds has its advantages and disadvantages. The interest on borrowed money is tax-deductible, while dividends and distributions paid to shareholders are after-tax distributions. In addition, interest rates are usually lower than the rate of return required by equity investors.

So, since the cost of money on debt is less than the required return on equity, why not borrow as much money as you can? The answer lies in having an understanding of the effects of financial leverage.

What Is Financial Leverage?

Financial leverage is a ratio of a company's debt to its equity capital. This metric is usually referred to as the debt-to-equity ratio. As an example of what this means, look at the balance sheet of the Hasty Rabbit Corporation, a manufacturer of sneakers for rabbits.

Hasty Rabbit shows total assets of \$800,000 on its balance sheet. These assets are financed with \$400,000 in debt and \$400,000 in equity capital. The debt-to-equity ratio is calculated as follows:

Debt-to-equity ratio = Total debt/Total equity = \$400,000/\$400,000 = 1:1

This means that Hasty Rabbit Corporation has \$1 in debt for each \$1 in equity. Lenders would consider this a comfortable ratio.

What Are the Effects of Financial Leverage?

The objective of a small-business owner is to maximize the return on equity capital, ROE, of both the owner's money and capital from outside investors. One way to do that is to minimize the cost of financing the business.

Suppose the interest rate for the debt of the Hasty Rabbit Corporation is 8%, and the investors require a return of 18% on their capital. With a capital base of \$400,000, The company needs to earn a net income of \$72,000 on \$1 million in sales to achieve an 18% return on capital.

What if the company's total debt was increased to \$600,000 and the equity capital was reduced to \$200,000. Net income would drop to \$60,200 because of the higher interest cost from more debt, but look at what happens to ROE. The ROE is now:

ROE = Net income/ Equity capital = \$60,200/\$200,000 X 100 = 30%.

The debt-to-equity ratio increased to 3:1 (\$600,000/\$200,000). What are the limitations of leverage?

As you can see from the example, increasing the debt-to-equity ratio substantially increases the investors' return on capital. In the case of Hasty Rabbit Corporation, the ROE went from 18% to 30%. Investors would be ecstatic. They have less money at risk and are making a higher return.

What would happen if the economy went down and sales decreased?

Increasing financial leverage increases the financial risk of the company. Let's look at the example of Hasty Rabbit again.

The \$400,000 debt repayable over 10 years at 8% interest would have annual principal and interest payments of \$58,236. Increasing the debt to \$600,000 with the same terms would raise the annual loan payments to \$87,348, an increase of \$29,112.

Suppose annual sales declined by 15% to \$850,000. Gross profit would decline, overhead expenses would stay the same, but cash flow with the higher interest cost of the \$600,000 debt would result in a negative cash flow of \$13,300. This raises the possibility of a default on the loan payments.

On the other hand, if the company had maintained it's \$400,000 debt and \$400,000 in equity, it would have earned \$15,800 net income, even after the sales decline of 15%. In this case, the company would have lower income but could still meet its debt payments on time.

Is Financial Leverage Good or Bad?

It depends. If the economy is good and sales are growing, then higher financial leverage results in a higher return on equity, and that's good. However, financial leverage has a whipsaw effect.

If sales decline, the company can incur losses quickly and face the possibility of defaulting on loan payments, and that's bad. As a small-business owner, you have to understand the advantages and disadvantages of leverage and decide how much financial risk you are willing to assume in climates of economic uncertainty.