Leverage Definition - How Leverage Can Benefit Your Business

how leverage works

By Jean Murray. US Business Law / Taxes Expert

Jean Murray has the education and experience to help you become an expert in your small business, and to provide you with information about business legal and tax issues. With an MBA and a PhD in entrepreneurship, she brings almost 30 years of experience and knowledge to these important business subjects.

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DISCLAIMER: I am not a CPA or attorney, and nothing on this site in articles, emails, blog posts, or other communications is intended to be tax or legal advice. The purpose of this site is to provide general information to readers. No claim is made regarding the accuracy or legal status of information on this site. Federal, state, and local laws and regulations change, and every business situation is unique. Readers should not take action on any tax or legal matter without reviewing options with a tax advisor or attorney.

Leverage  is a business term that refers to how a business acquires new assets for startup or expansion. If a business is "leveraged," it means that the business has borrowed money to finance the purchase of assets.  Businesses can also use leverage through equity. by raising money from investors.

Leverage can also be a verb, as in "Businesses leverage themselves by getting loans for expansion."

The concept of leverage in business is related to the principle in physics. In physics. leverage refers to the principle that a lever can give the user a mechanical advantage in being able to move or lift objects that could otherwise not be done. In the same way, businesses can use leverage to fund company growth and development through the purchase of assets, something that could not be done without the added benefit of additional funds, through leverage.

Here's how leverage works: 

A small retailer wants to

expand into the space next door in a strip mall.

In addition to the increased rent, the business will need to buy fixtures, shelves, tables, and other retailing areas, as well as additional inventory. Most small businesses don't have cash lying around to spend, so the business will need to get a business loan. This loan is leverage, to help the business do what it couldn't do without the loan.

Leverage is a good thing, as long as the business doesn't have too much debt. If a business, like a family, has too much debt it may not be able to pay back all of its debt.

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When considering a business loan application, a lender typically looks at the amount of debt leverage a business has currently, to determine how much more the business can have reasonably.

One way to look at the amount of leverage in a business is to calculate the Debt-to-Equity ratio, showing how much of the assets of the business are financed by debt and how much by equity(ownership).

Rosemary Peavler, at Business Finance. says:

In general, if the company is in debt more than 40-50%, the company needs to look at its financial statements  more carefully and compare itself to other companies in the industry as it may be in financial difficulty.

In the same way as borrowing, trade credit (using vendors as creditors ) can be a way to leverage your company's credit record with vendors as a financing mechanism.

 Equity as Leverage

Although business debt is most often used as leverage, businesses do use equity financing as leverage. In this case, a corporation's board of directors might approve a stock offering, encouraging new investors and using their investment as leverage for business growth.

If you want to read more about the physics behind leverage, Andrew Zimmerman Jones at Physics. has a good explanation.

Source: biztaxlaw.about.com

Category: Forex

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