What is leverage?
Running a business is expensive. Quintessential assets like office space, machinery and administrative costs can wipe out your capital before you even earn your first dollar. Leverage allows you to use your existing capital to have access to more capital. Common examples of leverage are mortgages and margin trading.
Financiers provide capital at more favourable rates when there are assets backing the loan. For instance, an unsecured loan can cost you anywhere from 5% to 36% per annum. A home equity loan, on the other hand, will probably be much lower.
When should you leverage?
Leveraging is a risk multiplier. What this means is that if you originally had a profit margin of 10% on your capital, doing a 10x leverage will mean that you have a 100% return before accounting for borrowing fees. Let us run through an example.
You have $100,000 in capital. This $100,000 is making you $10,000 every year. By leveraging 10 times and assuming the profits stay the same, you will be making a profit of $100,000. The net profit will then be the new profits minus the cost of borrowing the capital.
However, bear in mind the reverse is true. If the capital is making a loss, leverage will similarly multiple the loss by the leverage factor.
How should you leverage?
A personal unsecured loan is probably the most straightforward way to have access to leverage. Personal loans allow you leverage based on your monthly salary. However, for business owners, this may not be the most suitable loan as you require a high monthly salary and chances are you are paying high interest rates.
Banks offer corporate loans for both SMEs and MNCs. These loans assess your company’s financials and offer you a loan based on how risky the loan is. This loan is suitable for companies that are already mature and have years of financial statements and clean credit scores.
Home Equity Loan
For companies that are still growing, corporate loans may offer very poor terms. This is due to the nature of unsecured loans. Home Equity Loan bridges the gap by offering favorable rates in exchange for a collateralized home. This may be the best option if you have favourable profit margins and are looking to grow but is limited by capital.
Leverage is a tool that can work both in and against your favour. Making the best out of your existing capital requires understanding your past performance and predicting future performances. The right leveraging tool can accelerate the growth of your business if used in the right circumstances.