This article originally appeared in the January 2017 issue of Smart Business Philadelphia magazine.
Companies seeking to enter a new market, expand their business or make an acquisition would be wise to consider leverage to achieve their growth goals, says Brian J. Sharkey, director of Audit & Accounting at Kreischer Miller.
“Using leverage is an instant shot in the arm of capital,” Sharkey says. “If you go to a lender who is familiar with your company, you may be able to obtain the necessary capital to help achieve strategic goals and move on them quickly.
“Companies that choose to grow organically need to stockpile profits that would otherwise be given as a return to equity holders. They put it aside to build up capital and then use that internal cash flow to support the growth plan. It’s a slower process and in some ways, you’re sacrificing profit for growth.”
One of the keys to effectively using leverage as part of a growth plan is a strong relationship with your lender.
“Keep your lender abreast of the company’s performance and any significant changes,” Sharkey says. “Being proactive with your lender establishes a comfort level and gives you a little more leeway when something unexpected occurs.”
Smart Business spoke with Sharkey about what to consider when using leverage to grow your business.
What’s the best approach to take with a debt financing plan?
First and foremost, know the anticipated return on your investment. Typically, when a business obtains debt or another type of financing, it’s for a specific purpose. Most companies will have a plan for what they are trying to accomplish, but what many fail to do is quantify the anticipated return on investment that is expected to be created. If you do the math and find that your investment return is greater than the cost of debt, it’s probably something you want to consider pursuing. If you don’t go through the exercise, you may be leaving a lot up to chance.
It is also critical to stress test your plan. What happens if you don’t meet sales obligations? What if your profits aren’t what you expect? It is important to run various scenarios and use the findings to make informed strategic decisions. It’s important to have a plan, but it’s also useful to have financial information to back it up.
Do you see any common mistakes when businesses take on debt?
Typically, it’s not a good idea to borrow on a long-term basis for short-term needs. Long-term financing should be lined up with long-term goals and initiatives. Financing tools such as a line of credit should be held for working capital needs like the financing of receivables or inventory on a short-term basis. A good way to look at this is to line up leverage with the assets you’re acquiring so the debt service period matches the time period you expect to receive returns from the asset. Otherwise, if things turn sour, you could be obligated to make debt service payments before receiving the benefits from an acquisition or machinery purchased.
What’s another reason to consider leverage or debt financing?
The cost of debt is much cheaper than the cost of equity. If you can properly balance the leverage and equity, you can increase the overall profits and increase the return on equity.
For example, if you have $10 million of equity in your company and you’re making $1 million a year, that’s a 10 percent return on equity. But what if you went out and got $10 million of capital via debt? Now you have $20 million of capital in your company. You may be able to double your profits to $2 million and may only have to pay $500,000 of interest to the lender.
The end result is with the same $10 million of equity, you have $1.5 million of return coming to the equity holders. You can increase the value of your company as well as increase equity returns just by adding some leverage. ●
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