Understanding leverage

the ofnag-visorsAdvice from the professionals Understanding Leverage

By Jessica Allan

In the banking world, there is a lot of jargon, myriads of acronyms, and it can be hard to remember that not everyone knows what they mean. A lender can talk about cash flow, DSCR, leverage, debt-to-net worth, capacity, LTV, DTI, etc., but unless those are explained to the borrower, quite often the only response is a blank stare.

One term being thrown around a lot today, especially when comparing today’s economy to the Great Recession of 2008, is leverage. Merriam Webster defines leverage as 1) the action of a lever or the mechanical advantage gained by it, 2) power or effectiveness, and 3) the use of credit to enhance one’s speculative capacity.

That last definition is to what a lender is referring when discussing a borrower’s financial status. Businesses use leverage to improve their assets, generally, but it is a sharp edged tool that, if handled incorrectly, can bite a business owner in the end.

As a previous lender and now credit analyst, there are two common methods I have seen businesses use leverage. One is offer assets as additional collateral on a purchase, instead of a cash down payment. While allowing the business to keep their cash (liquidity) available, it can have a negative affect on the business’ payment schedule. A second common method is to obtain debt against an asset for other purposes than financing that specific asset. An example would be using farm machinery and equipment that is owned free and clear as collateral on a line of credit for a crop operation.

Both methods mentioned make perfect sense for many businesses, but when and how does it become a concern for a lending institution? One of the many reasons many institutions ask for annual financial statements is to take a measurement of business’ leverage. A common measurement is a ratio: debt to net worth. This ratio is computed by dividing total debt by net worth. It can show how much debt a business has in relation to net worth, which in turn indicates if a business has over-extended itself, and if necessary, could repay all debt back by selling their assets. A ratio of more than one means a business has more debt than they do net worth.

High debt to net worth ratios are common in new businesses starting out with large debt. A higher ratio is generally considered to indicate that the business is a riskier investment. Leverage can be a great tool, especially in short term situations, like a line of credit used for input costs that will be paid back in full once crops are sold, or for start ups that don’t have access to many assets yet. However, it can lead to a business becoming riskier and experiencing higher costs associated with that debt that can impact repayment down the line. This can be especially impactful when asset values start to decline and interest rates increase, a scenario that may possibly be playing out in today’s economy.

It is up to each borrower and their financial advisors to decide if using leverage in the business is a tool to be used at that time or not. If it has been used in the past, and has become an issue today, that is when the relationship between the borrower and their financial advisors becomes even more important, so that discussion and decisions can be made before the issue worsens.

Jessica Allan is an agricultural lender and commercial relationship manager at Guaranty Bank in Carthage and Neosho, Mo. She may be reached at jallan@gbankmo.com.

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