Leverage basically refers to borrowing money at cheaper rate to invest in assets with higher rate of return, thus resulting in a profit. If the business conditions stay good, this can result in a good profitable situation for the business owners. However, if the investment turns out bad, it might end up in a result which is not so good from an owner’s point of view. Let’s run through two scenarios for the hot dog owner:
Scenario 1 (with debt): The hot dog owner has $50,000 to start his business. Let’s say he borrows another $50,000 @ 10% per year (i.e. an interest expense of $5,000 per year) to setup the business in double the size since he believes that there is a good opportunity to earn more money by setting up 2 shops. Assume both shops are setup in two malls with similar footfall i.e. similar number of customers visiting every year. Assume cost of goods sold and SG&A to be constant at $40,000 per shop. Assume profits to be taxed at 25%.
Case 1: Business is great and both shops make $70,000 per year
Case 2: Business is not so great, a new pizza chain opens shops right next to both hot dog shops and kills the sales. So the total revenues are now $80,000 ($40,000 per shop).
Scenario 2 (without debt): Here, the hot dog owner opens only one shop with his equity of $50,000. Assume cost of goods sold and SG&A to be constant at $40,000 per shop. Assume profits to be taxed at 25%.
Case 1: Business is great, shop makes $70,000 per year
Case 2: Competition from pizza shop drives the revenues down to $40,000 per year
In the above examples, we have made the numbers such that the Case 1 for both Scenarios show a jolly picture of business while Case 2 shows the worst case scenario for the business. Let’s try and understand the economics of leverage now:
As you can see, when the business is doing well, taking some loan actually increased the amount of net income available for hot dog owner. His return on equity increased from 45% to 82.5%. So leverage can amplify returns in good times. However, take a look at the scenario when business is not doing well. Without debt, the business makes no profit. But with debt, the hot dog owner has to pay interest on top of the expenses, leading to a net loss. So the net return on equity worsens from 0% to -10%.
Hence, it is always good to analyze the amount of debt carried by a company. There have been instances where the companies used a lot of leverage and could not pay back the loans resulting in creditors taking control of the assets and liquidating the business, thus leaving nothing for the owners.