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Business loans aren't just used for short term cash management are buying long term assets.

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Loans are a critical component of business plans.

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Financial leverage which is the use of borrowed money magnifies returns.

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Business and Investment gurus tout how you can make big money with little money of your own.

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They show how using other people's money can make you rich.

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It's true that using other people's money known by the acronym OPM can increase your returns.

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But OPM can also be like the drug OPM its highs come with crashing lows borrowing large amounts of money

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increases the risk your business may run out of cash or have big losses in a downturn.

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I'll explain how this works and how to reduce your risk.

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I'm going to go through a formula and a couple definitions but don't freak out if you don't quite follow

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all this.

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I'll show some examples in later slides.

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Even if you don't fully understand the numbers I want you to understand the concept that debt magnifies

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both returns and risk return on equity as how much the owners earn on their investment in the company

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return on assets is income divided by the assets of the company.

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It's a way of measuring how profitable the assets are.

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Those two returns are related.

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Return on equity is equal to return on assets.

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Times leverage.

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So that first Formula leads us to ask what's leverage and how do you measure it.

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Leverage refers to how much debt you have in the ROV equation.

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Leverage is measured as one plus the debt to equity ratio.

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OK so what's the debt to equity ratio.

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It's your debt divided by your equity.

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In other words it's how much you've borrowed divided by the accounting value of your company.

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A ratio of one where debt and equity are both equal means the company has borrowed as much as the owner's

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accounting value in the company borrowing more debt causes the debt to equity ratio to go up.

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Like I said your head may be swimming a little from the formulas.

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Here's an important concept from the formula.

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Leverage by itself doesn't increase your return on equity but it does magnify it.

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Here's another way of saying this borrowing money doesn't increase the return to the owners but it magnifies

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it.

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So what do I mean.

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It magnifies return on equity.

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If your return on assets is highly positive borrowing money usually makes the return to the owners the

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ROV go up.

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However if the return on assets is negative borrowing money will make the return to owners to become

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much more negative.

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I'll show two examples to explain this more let's look at how leveraging a company magnifies its return

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on equity.

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In this example the company has one million dollars in assets.

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They have a few miscellaneous liabilities like accounts payable but no business loans.

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Their debt to equity is a very low point one 1.

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Their profit is one hundred thousand dollars so they have a return on assets are a way of 10 percent

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and a return on equity or ROIC of eleven point one percent the owners then decide to get bank loans

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to invest in company assets to magnify the return on equity.

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This is the second column.

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They borrow two million dollars so the total assets are now three million dollars.

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For simplicity let's assume they still earn 10 percent on their assets before interest costs.

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Their profit before interest expense is three hundred thousand dollars.

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Assume the loan has a 7 percent interest rate.

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They would pay one hundred and forty thousand dollars of interest expense.

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So their net income is one hundred and sixty thousand dollars.

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Their return on assets decreased from 10 percent to 5 percent because they now have to pay interest

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on the cash they got to fund the additional assets.

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However the return on equity has jumped from eleven point one percent to seventeen point eight percent.

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In other words leverage cut their archway in half but increase their ROIC by 60 percent.

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The owners are making a lot more money.

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What could go wrong

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once again.

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Leverage doesn't increase ROIC it magnifies it.

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Many business owners hear about how leveraging using other people's money can make them rich.

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That assumes a decent on leveraged are a way a lower negative archway can cause massive negative ROV

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and cash outflows.

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The dark side of leverage is shown in this example.

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Our sample company is now earning a small loss.

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The first column shows their results with no leverage.

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They have an hour away of negative 1 percent and an army of negative 1 percent.

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Their net loss is ten thousand dollars which is probably fairly manageable with one million dollars

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in assets and nine hundred thousand dollars in equity.

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Now look at the leverage column they have three times as many assets so their lost before interest is

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three times larger.

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A thirty thousand dollar loss may not hurt them too badly but they also a one hundred and forty thousand

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dollars in interest.

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There are way after leverage is minus 6 percent and there are we as a negative 19 percent.

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To summarize a small negative way an ROV with no leverage has been magnified into a massive negative

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ROV through leverage.

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There are we with leverage is 17 times lower than without leverage.

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The biggest problem isn't earnings.

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It's cash flow.

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Companies fail from lack of cash flow not lack of earnings.

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Most owners plow the full two million dollars of borrowed money into non liquid assets like real estate

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or equipment non liquid assets or assets that cannot be easily sold or otherwise turned in the cash

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they may have even used some of their cash when they had only one million dollar in assets as their

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down payment or equity portion of those illiquid assets.

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They may have nowhere near the cash left to service a one hundred and seventy thousand dollar loss as

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a banker.

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I saw this happen with many business owners during the Great Recession.

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Real estate investors and owners who made big expansions before the downturn were caught with little

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cash and big payments.

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To put this all together you must balance both profit and risk when deciding how much to borrow and

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how to use the cash from that borrowing.

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Borrowing funds to increase your investments and grow your company can cause the return to owners to

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greatly increase.

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On the other hand the return to owners is decimated.

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If the investments start earning low or negative returns.

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More importantly than earnings is cash flow.

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When you have decent income from investments it's not hard to cover your loan payments.

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You will need to have a good reserve of cash available for your loan payments when earnings falter though.

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I encourage you to keep a larger reserve of cash as your borrowing increases the increased borrowing

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increases both your profits and your risk over the long term.

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The cash reserve will allow you to keep most of the profits and reduce your risk using leverage and

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keeping reserves mean you will receive higher returns during the good times while covering your loan

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payments and losses during the rough times.