Leverage 101: What is Leverage and How to Scale a BusinessUsing It
If you’re a business owner, you may have come across the concept of ‘leverage’ and may be wondering what the best way is to use to grow your business.
The word “leverage” is thrown around a lot in business, making it sound more complicated that it is.
But when properly understood, leverage is an extremely useful tool that businesses of all sizes use to grow their asset base – from inventory to purchase equipment.
Below, will outline in detail exactly what leverage is, how leverage works and also discuss the different types of leverage. We will also outline step-by-step how you can use leverage to scale your business.
What is leverage?
Leverage is the use of debt to help your business achieve a larger financial or commercial objective.
To use a common example, leverage will involve borrowing money for a purpose, with a view to repaying that money on a schedule with interest.
It sounds like a loan (which it is), but it is a specific type of loan which you are using to grow and scale your business.
How does leverage actually work?
When your business is ready to scale its operations, you’re going to need money to do it.
This applies whether you’re planning to expand into new markets, purchase new equipment and machinery or update the infrastructure you currently have.
The thing is – if you don’t have the funds, you’ll need to borrow them.
Usually, the two primary ways to borrow capital in business are as follows:
- Equity financing – this is where you sell your equity in exchange for funding. A significant benefit to this is that you will not have to make any financial repayment or interest repayments. You can ‘equity finance’ through strategies like issuing bonds, launching an Initial Public Offering (IPO) or crowdfunding.
- Debt financing – this is where you borrow money to finance capital requirements. You will need to repay the principal and the interest.
3 main benefits of leverage
The central benefit of leverage is that you are able to achieve more with less. Broken down into three parts, the benefits are as follows:
- You can build wealth. Leverage allows you to boost returns on your financial investments as much as possible, allowing you to build wealth in a sustainable way.
- You can grow your business.Leverage allows you to save time and money, find ways to be efficient, gain new information and grow your business to levels never previously experienced.
- You can boost your business’ productivity. By harvesting your time, your resources and your relationships, your entire business can boost its efficiency, be more productive and accelerate towards its goals.
Types of business leverage
To really understand the nitty-gritty of what leverage can help you accomplish, it’s important to understand the types of leverage in business.
Financial leverage refers to using money you’ve borrowed from somebody else to gain something for yourself or for your business. It refers to how much debt your business has acquired, usually represented by liabilities on your balance sheet.
Businesses will normally increase their financial leverage through investment and debt financing strategies. It is best practice to keep a low financial leverage ratio to ensure your business remains stable.
Operating leverage refers to when your operating expenses are fixed, but your profits and revenue is growing.
To calculate this, you simply divide your fixed costs by your variable costs.
Your fixed costs are the costs that do not change and must be paid regardless of whether your business is making money. Your variable costs are the ones that change depending on how much you produce.
If your business has a high operating leverage, thatmeans you will be losing more money overall when your revenue decreases.
Combined leverage refers to the effects of bothyour financial and operating leverages. It presents a full picture of the financial health of your business. This is calculated by adding operating leverage and financial leverage together.
This type of leverage is especially useful in businesses that are capital-intensive, but don’t have that much cash or equity. But it needs to be used carefully, as you’ll need to be fairly certain of your company’s expenses in the future.
Other leverage (time and relationships)
The most important leverage in a business is that of the human beings running it. This can be split into two different types:
- Relationship leverage – when you surround yourself with the right people, you can use your relationships with them to achieve your goals.
- Time leverage – time is our most previous resource. By using other people’s time to accomplish your tasks, this gives you more hours in the day to do what you need to do. For that reason, time leverage basically means getting really good at delegating.
How to use leverage to scale your business
When used correctly, leverage has the potential to accelerate your business towards its goals and become a fundamental driver of growth.
To use leverage to scale your business, it is important to focus on five things.
- Identify “high leverage areas” in your business
The first step is to think about where in your business has the highest potential to generate the most growth.
This could be a new product, a new service offering, a marketing initiative or something entirely different that is industry-specific to you.
It is important not to spread yourself thin but, instead, ‘double down’ and focus on the high-leverage points to focus and get the most out of them.
- Put together a “master plan”
Putting together a clear plan of action is critical for anything you do in your business. It is especially important when you plan to leverage your resources.
This will most likely involve putting together a marketing strategy and a business plan to ensure long-term growth. This could include a plan to generate leads or outsource work to experts so you can focus on your core business.
The plan should be flexible and adaptable.
- Take action and reflect on your results
Once you’ve put your plan together, take action! Execute your plan and see what happens. Once you’ve taken said action, reflect on what worked and what did not work.
Ask yourself questions like:
- Did you hit your Key Performance Indicator (KPIs)?
- Did you achieve the goals you set for yourself in your business plan?
- What can I do next time to make sure that something doesn’t happen?
Ensure your reflection (and subsequent action plan) is focused on the data – do not simply ‘guess’ what will work.
- Take action again
The key is consistency. Always keep taking action, adjusting and reflecting until you reach the results you want.
Keep going again and again, until you’ve taken your business to where you want it to go (and beyond).
3 disadvantages of leverage
Not everything is sunshine and roses. There are unfortunately ways that leverage can go wrong – primarily when it is overused or used incorrectly.
If you have too much financial leverage, the following risks may arise.
- Your business may face solvency issues – the more your company is in debt, the more it becomes difficult to pay back. Financial institutions will look at your leverage ratios (for example, your debt-to-equity ratio) before lending you money. Having too much debt on your books unfortunately reflects a risky costs structure, and getting additional money can become very difficult, very quickly.
- You may pay higher interest rates – if you’re experiencing long-term debt, then leverage can really eat into your bottom line. If you are perceived by lenders as risker, then they may decide to make you pay higher interest rates.
- You may liquidate – if your businesses becomes insolvent and you are forced to liquidate, then this essentially spells the death of your company.
Where you can get help with your leverage
If you’re looking for a partner to help you with your financial leverage, then the best step for you is to speak to one of our financial experts here at 2account.
Our accounting services are specifically designed to help you take advantage of your financial leverage. We can go deep into your books, and help you determine what steps you should take in order to avoid insolvency and liquidation, all while scaling your business.
Please get in touch by leaving a message here, or giving our team a call on 1800 795 661.