Managing Your Business Leverage

Business leverage is a process of managing the amount debt a business takes on in order to accomplish their purposes. Managing leverage is important to ensure that the business is financially solvent and able to meet its obligations as they arise in order to avoid a financial crisis or bankruptcy. This is done on a periodic basis by the business as they acquire and discharge debt and should a part of their regular financial review.

Reviewing Business Leverage

On a periodic basis, a business looks at its overall debt relative to it value measured in equity. If you looked at a business’s balance sheet, which is a capture of a business financial status at a point in time, you would look at the numbers on the right hand side of the ledger. This constitutes the business’s liabilities or debts, which consists of short and long-term obligations. This amount is over the total equity of the business, which may also be referred to as shareholder’s equity. Total equity or net worth of a business is derived by taking its assets on the left side of the ledger and subtracting its liabilities (A – L = NW).

Calculating Business Leverage

Dividing the equity by the total equity of the business will give a ratio that represents the business’s leverage. This ratio should be 1 or less, representing a proportionate amount of debt relative to equity. A ratio of 1-1/2 to 2 times debt to equity is indicative of a company that is too leveraged and may potentially be facing financial difficulty, including bankruptcy.

A Business That Is Highly Leveraged

A company that is highly leveraged should look for ways to reduce its debts or consolidate older debt that may help make it more appealing on the business’s balance sheet.  A business that has a high business leverage ratio should also be encouraged not to take on new debt as this will increase the ratio and add to its potential financial calamity.  It is the responsibility of a business in its review process to ensure that the level of debt that it takes on is reasonable relative to its equity position and set a number that keeps the business leverage ratio low.

Businesses that manage their leverage properly by performing a simple calculation of Total Debt divided by Total Equity will find itself well positioned for growth and additional opportunities.  A business that takes on more debt that what can reasonably managed will find it difficult to manage that debt over a long period and will certainly face financial crisis at some point.