I speak to a lot of business owners. Occasionally, I will speak with one who tells me that they operate debt free and have a fear of operating with leverage. That’s fair. Debt isn’t for everyone. But I wonder if those folks have considered the positive aspects of leverage. Used in measured ways, leverage can be a tool to help a business owner achieve economic returns.
Here’s a parable that boils this down to some basic parts:
The Nickel Machine
Let’s suppose that some genius builds a nifty (and perfectly legal) machine that does one thing: makes nickels. At the end of each year, it spits out one shiny, new nickel. The inventor of this machine manufactures ten Nickel Machines and decides to sell them for $1 each. Now let’s also suppose that you have $2 in your pocket. Assuming the machines don’t decrease in value, if you used your $2 to purchase two machines, at the end of the year, you’d own two machines valued at $2 and two shiny nickels, for a grand total of $2.10 in assets. Doing some quick math, you determine that you made a 5% return on your investment. Not too shabby, right?
Let’s further suppose that a local bank is willing to loan you an additional $8 to purchase all of the remaining machines. The catch, though, is that the bank would need to collect four cents per year for each dollar that you borrow and that if you don’t make your payments, the bank gets the machines. Does it make economic sense to purchase all ten of the machines? Let’s do the math.
If you use your $2 and the bank’s $8 you would own $10 worth of machines and owe $8 to the bank. At the end of the year, you would own ten shiny new nickels, but you would also need to pay the bank $0.32 for the money that you borrowed. So at the end of the year, you would own $2 worth of machines ($10 minus the $8 you owe the bank) and $0.18 in change (the fifty cents the machines gave you minus $0.32 in interest payments) for a grand total of $2.18. In this scenario, you started with the same $2, but ended up with $0.08 more than if you would have just purchased two machines. Your return on your two dollars using leverage is now 9% ($0.18 divided by $2). The leverage provided by the bank resulted in a real economic benefit to you.
This is a simplified example of why leverage can be a good thing. Substitute the Nickel Machines for inventory, equipment, a building, and you can see a similar effect.
While some leverage for your business can be a good thing, too much can lead to disastrous results. That’s where we can help. At Marine Bank, our experience helps us understand the appropriate amount of leverage for your business, so that you can maximize your economic results. To learn more, contact one of our Marine Bankers today.
Written by Eric Flick, VP Commercial Lending Officer