Taking a Chance on Debt for Financial Leverage

To run a business, you need financial backing, otherwise known as capital. In broad overview, a business raises capital needed for its assets by buying things on credit, waiting to pay some expenses,

borrowing money, getting owners to invest money in the business, and making profit that is retained in the business. Borrowed money is known as debt; invested money and retained profits are the two sources of owners' equity.

The large majority of businesses borrow money to provide part of the total capital needed for their assets. The main reason for debt is to close the gap between how much capital the owners can come up with and the amount the business needs. Lenders are willing to provide the capital because they have a senior claim on the assets of the business. Debt has to be paid back before the owners can get their money out of the business. A business's owners' equity provides a relatively permanent base of capital and gives its lenders a cushion of protection.

The owners use their capital invested in the business as the basis to borrow. For example, for every two bucks the owners have in the business, lenders may be willing to add another dollar (or even more). Using owners' equity as the basis for borrowing is referred to as financial leverage, because the equity base of the business can be viewed as the fulcrum, and borrowing is the lever for lifting the total capital of the business.

A business can realize a financial leverage gain by making more EBIT (earnings before interest and income tax) on the amount borrowed than the interest on the debt. For a simple example, assume that debt supplies one-third of the total capital of a business (and owners' equity two-thirds), and the business's EBIT for the year just ended is a nice, round $3,000,000. Fair is fair, so you could argue that the lenders, who put up one-third of the money, should get one-third, or $1,000,000, of the profit. This is not how it works. The lenders get only the interest amount on their loans. Suppose the total interest for the year is $600,000. The financial leverage gain, therefore, is $400,000. The owners would get their two-thirds share of EBIT plus the $400,000 pretax financial leverage gain.