Leverage in Business

Financial and Operating Leverage

In the simple lever and fulcrum machine the force is magnified onto a load.  The machine creates a mechanical advantage, a form of force amplification.  In business the principle is exactly the same.  Except here we are not moving a physical object but the objective is to amplify the profitability or financial gain by using some form of a lever and applying this lever to a fulcrum and generating financial advantage.

Leverage is a term used in business and has several different meanings depending on the topic of the conversation.  Most folks respond in a similar way when asked about leverage in business.  They recall the recent financial leveraging that occurred in the 80’s and 90’s related to increasing the debt ratio of a business and leveraging that debt to increase the volume of activity and therefore generating the necessary margin to service that debt.  This is just one form of leverage in business.  The other form of leverage is called operating leverage. 

Operating leverage has three different methods.  Each can generate significant gain in the overall profitability of the operation.  The methods include process and product leveraging; and employee utilization.  The following sections explain each of these along with defining the lever, the fulcrum and the corresponding gain.

Financial Leverage

There are two types of financial leverage.  The first and most common is equity based leverage.  Simply stated investors use their own money to provide the proper level of financial resources to ramp up the company to the appropriate size and maximize profitability.  This profitability is then returned to the investors as earnings on their investment and the cycle continues.  Each industry is unique in the financial dynamics necessary for the equity to work properly.  Most small business owners use insufficient equity investment and therefore have difficulty generating adequate profits. 

To offset this lack of equity investment many smaller organizations use the second type of financial leverage – debt.  One of your more common financial leverage tools at the small business level is an auto loan.  Here an asset is purchased using the credit worthiness of the owner.  A long term debt is utilized to purchase a working asset.  The hope is that this asset will generate sufficient income to offset the debt service required for the asset. 

In big business debt is used to expand operations or add new divisions of product or services.  The idea is simple, any marginal values generated by the additional product or division will service the associated debt.  Ideally not only is the debt serviced but there is an increase in overall profit of the company thus creating more wealth for the owners without risking their equity.  Basically financial leveraging is risk shifting of capital. 

In financial leverage the lever is the debt, the fulcrum is expanded operations and the weight lifted is the increase in revenues generated from more sales of additional services or products.

Wow, this seems like an easy solution to business.  Why wouldn’t all small businesses borrow more money and ramp up operations and generate more sales?

The key is the ability to borrow the money.  Lenders are savvy and as the associated risk of the loan increases so does the interest rate.  For small businesses the risk to the lender is generally greater than the value of the return on the loan.  Therefore many banking and lending institutions do not loan money to small businesses.  So many small businesses utilize credit cards to leverage the operations.  The associated interest charged for the use of this money eats into the profits generated by the use of the funds from the credit card.  In almost every case, it doesn’t work.

Even at the big level, financial leverage doesn’t work:

American Airlines manages its balance similar to other airlines.  Debt is a significant portion of the overall capital needed to operate an airline.  Creditors have airplanes as assets to collateralize the debt.  However, the overall economic situation impacts operations greatly.  Prior to the economic downturn in 2008, American Airlines reported a $506 Million profit in 2007.  Over the course of the recession, American Airlines lost $6 Billion from 2008 to 2011.  American Airlines went bankrupt. 

On their balance sheet in 2011, AA had $14.3 Billion in fixed assets and carried $22.2 Billion in long term debts.  Interest paid in 2011 exceeded $811 Million. 

In 2007 AA carried $17.3 Billion in fixed assets and had $17 Billion in long term debts.  Interest paid in 2007 was $914 Million. 

In this four year span, the fixed asset to long term debt ratio went from 1.01 down to .65 which means AA increased the financial leverage dramatically.  This means that to cover this increased leverage AA needed a significant increase in revenue to generate the necessary margins.  Revenues were $23 Billion in 2007 and decreased to $19 Billion in 2011 mostly a result of the economic downturn.

In small business I see financial leveraging all the time.  A good example and one most readers can relate to are your house flippers.  Here they borrow the money to purchase and renovate a home and then sell the property for more than the actual amount borrowed, thus making money on the difference at closing.  This type of business is almost purely financial leverage.  But just as in the American Airlines example above, it can haunt the house flipper.  If the amount borrowed is greater than the final closing proceeds, the house flipper must come out of his own pocket for the loss.  I have seen this several times in my accounting career and I can tell you it isn’t easy for the owner to cough up 10 to 15 thousand dollars to cover the difference.

So financial leverage has its place in business and if used appropriately and wisely it can generate significant profits for the owners of a small business.

Operating Leverage

This form of leverage uses the corporate operations as the overall leverage device.  The key is fixed costs as a percentage of total costs.   As fixed costs increase and the variable costs decrease for each unit of sale the margin generated (revenue less variable costs) increases.  Therefore each incremental unit of sale after covering all fixed costs (breakeven point) contributes greatly to the profitability of the business.  One of the best examples is hotels.

In the hospitality industry high fixed costs is one the financial attributes.  With hotels there is a large significant upfront cost of construction, marketing and staffing to receive the very first guest.   On average the hotel breaks even if occupancy can exceed 58% each night.  With each additional room rented after the 58% point there are only variable costs required to take care of that guest.  The variable costs include cleaning the room the next day, laundry, toiletries, a little extra utilities and not much more.  The guest pays $100 for a room and the variable costs are in the neighborhood of 16 – 20 dollars.  So each additional room rented beyond the breakeven point contributes significant dollars to the profitability of the hotel.

Another example is a golf course.  Here almost all costs are fixed in nature.  Whether that course has one paying customer or 175 in a day the costs to run the golf course are unchanged.  The variable costs per golfer might be the cost of the scorecard, pencil, and maybe a little sand and seed to repair the divots out on the course.  So any unit of sales beyond the breakeven point puts a lot of dollars into the cash register for profit.

Both the hotel and the golf course are using product leveraging.  Basically the high fixed costs acts as the lever, the sales are the fulcrum and the profit is the weight that is lifted.

Some industries are inherently difficult to create operating leverage due to the high variable costs associated with their operations.  Think of a car dealership.  Each unit of sale has a very high variable cost, mainly the cost of the car.  So to gain operating leverage in this industry the dealerships expand operations by increasing the fixed costs of other departments.  This is why many dealerships have large service departments. 

Another example of a high variable cost industry is gasoline stations.  The margins from the sale of each gallon of gas are relatively low so to leverage this type of operation the stations have many pumps.  This is the theory utilized by WA-WA and 7-11.

To give you an example of leveraging people, those businesses that rely on very well educated employees to generate value leverage them by developing products that are utilized over many years.  Good examples include your pharmaceutical companies via research and development and software developers.  Each marginal unit of sale has very low costs to create (cost to produce a pill or copy the software) and so the initial cost to develop the product is the fixed component i.e. the salaries of the staff.  Again the lever is the initial cost to develop the product for sale via the high salaries over extended periods of time to create, research, develop and test the final product.

For those of you interested in understanding an operating leverage related to process.  Think of the substitution principle for human labor.  If you replace the human (variable cost in business) with a machine (fixed cost in nature) you leverage the process of production.

Summary

Leverage in business comes in two forms.  The first is financial in nature and is customarily reported on the balance sheet.  Basically the business uses debt to increase volume of operations and therefore profit.  The other form is found in the profit and loss statement.  This is referred to as operating leverage.  Here variable costs are substituted with fixed costs.  Each additional unit of sale has low variable costs and therefore can contribute to the profitability of the business at a faster rate than traditional operation.

As a novice or intermediate business owner you should also understand the associated risk for each.  When financial leveraging is used, the lack of sales or insufficient marginal revenue will cause profitability to decrease.  The key here is that financial leverage comes at a cost of increased interest that is due on the debt which absorbs the marginal gain from any increase in sales.  So sales must increase significantly to warrant the use of debt as the lever.

If considering using operational levers, the result is similar in nature.  The breakeven point increases as fixed costs increase and therefore slight decreases in revenue can quickly affect the profit of the business.  So if you are considering using leverage you should first determine the marginal increase in revenue required to offset each form of leverage.  Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org.  I would love to hear from you.   If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer. 

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About David J Hoare 429 Articles

I spent 12 Years as a Certified Public Accountant,
Over 20 Years of Practice in Accounting and Consulting,
Controller in Management of Closely Held Operations,
Masters of Science in Accounting,
Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns