The Economics of Leverage

Every individual has mixed feelings about debt. Some people refuse to borrow money, others think it’s okay to borrow responsibly. Yet, others borrow too much and live on the edge of bankruptcy. So from a purely economical point of view, how should a business view debt?

To answer this question, we need to consider the basic accounting equation, which is Assets = Liabilities + Net Worth. This means that everything a business owns (its assets), are funded with either debt (liabilities) or personal capital (net worth). Now consider you are a business owner who needs $100,000 to purchase equipment. That means the business owner will need to fund the $100,000 with his own capital, or debt, or some combination of both. If he pays for it all out of pocket, it costs him $100,000 immediately. But, the more he can borrow, the more he can save his own money. Say a lender will allow him to borrow 75% of the cost of the equipment, so the business owner will only need to invest $25,000 of his own money. With only needing to invest $25,000, a business owner could save $75,000 for other purposes.

If a business owner wanted to pay cash for a $100,000 purchase, and he didn’t have cash, then he would probably need to sell part of his business to raise the cash. You can see why this would be undesirable. If part of the business is sold, the original business owner will need to share profits and possibly even allow someone else to have a say in how things are run. Selling ownership is probably a last resort, and it creates incentive to borrow as much as possible. Really, it is in the business owner’s best interest to borrow as much as possible, so they don’t have to sell part of the business or use their own cash. Then why can’t a business owner borrow all the money he needs, and never have to sell or use his own cash?

While it would be ideal for a business owner to borrow 100%, it also makes it easy for them to walk away from the debt if the business isn’t working out. As we well know, lenders require a down payment for virtually all large purchases, thereby not allowing people to borrow 100% of the cost of the purchase. The reason a lender requires a down payment is so the borrower has something on the line to lose. So if a business owner wanted to purchase $100,000 in equipment, the most he could borrow is $75,000 if a lender requires a 25% down payment. With a down payment of $25,000, then the business owner stands to lose this and the equipment if he doesn’t repay the loan. This gives the business owner motivation to stick with making his business work, and making sure the loan gets repaid.

It may sound strange, but many successful businesses want to borrow as much as possible. This preserves cash and preserves ownership. Really the lender is the only person stopping the business owner from borrowing 100% for everything. Note, business leverage is very different than consumer debt. Consumers borrow to consume, or usually purchase things that rapidly depreciate. The more they borrow, the harder it will be to pay back their debt. Whereas, a business borrows to generate more income, so borrowing should lead to more profitability if done appropriately. This is another key reason why analysis of debt for businesses needs to be approached differently.