How Leverage Works

How Leverage Works

A widespread method in investingis using borrowed money. Most people buying a house put up anywhere from 10% to 25% and borrow the balance. That leverage is substantial – 75% to 90%. People also do this all the time with businesses. A previous blog explained leveraged buyouts (May 29, 2012). Today, I will show you how the numbers work.

Let’s assume a business is for sale for $1,000,000 and earns $200,000 pretax per year. A buyer putting up the entire $1,000,000 will get a 20% return on investment (ROI).

Using that same business, a buyer that borrows $500,000 and pays an interest rate of 10%will havethe$200,000reduced by the $50,000 interest.He now makes $150,000. He invested $500,000 from his own funds so his ROI is 30% ($150,000 / $500,000). Not too shabby.

To go even further, let’s assume he borrows $750,000 also at 10%. He will now make $125,000 on his $250,000 investment for a 50% ROI. This is how leverage works. You use other people’s money to offset using your own funds and youincrease your ROI. The amountinvested is called “equity.”

If you’re buying the business to work in itand have all the funds, it probably would not pay to leverage your investment unless the ROI on your remaining funds would exceed the interest you would pay for the loan. However, if you are in the business of investing in businesses and leverage permits you to increase your portfolio of businesses, you can become quite rich using other people’s money.

There are risks. The greater the leverage, the less likely you can recover from a business downturn or temporary setback since your equity could be wiped out or the interest payments could exceed the profits. Large leverage leaves little room to maneuver. Another danger comes from success that is too quick. Rapidly growing businesses need cash and linesof credit to absorb sharp increases in accounts receivable and inventory. Growth is a good problem to have, but it needs funding and that needs planning to have it available when needed.

If you willonly be buyingone business, then you should consider less borrowing; but if you buy businesses as a business, leverage might work very nicely.