Nick Pettus, CPA & Business Advisors/Tax Accounting Preparation Services
The Case For Financial Leverage
What is Financial Leverage? Simply put, it's means making more money by using Other People's Money. Why would you want to do this? Simply put, as long as you make more money back doing business than the cost to borrow, you multiply the return on your personal money invested in the business. Here is a depiction of Financial leverage below.
Notice, with no financial leverage, i.e. all the investment is your personal money, for every dollar you invest, you only get 20 cents. However, if half the money for the business is from a loan and half yours, even with an interest rate of 15%, (very, very high), your return on the money you have invested, only half now, increases to 25 cents per dollar. There has been a 25% increase in your return!! So what's the tradoff? well, the trade-off is even more abstract than what is shown here. It is something called Business Risk. Simply put, the more costs of doing business, the greater the chance the business may fail. So even though you have a greater return on your invested capital, there now is a greater risk, because of intersts payments, that the business may not succeed. So the question becomes for a business owner: Given my particular business, what additional business risk due to financial leverage is justified by an increase in the return of my capital invested?
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