The Ongoing Management Of Financial Leverage

While it is absolutely true that any type of long term, scalable business venture will utilize financial leverage to provide the necessary capital to operate as well as reduce the weight average cost of capital of the owners, leverage comes with costs and challenges that cannot always be directly quantified.

To depart into finance 101 for a second, when the after tax cost of debt is lower than the opportunity cost of equity, it only makes sense to utilize debt to bring down the overall or weighted cost of capital necessary to run a business.

Even if the business is debt free, operating strictly on its own cash reserves, the argument can be made that debt financing would allow the owner or owners to withdraw capital in order to investment in additional profit centers which in turn will make more money.

In theory it all sounds good and in practice, debt financing, especially at today’s rates, make a great deal of sense to take advantage of.

In practice, while leverage is almost always going to be necessary for some point in time, the ongoing management of third party debt or investment should not be underestimated either.

Put another way, any time someone else gives you money for a fee or return, they are someday going to want the money back. And while financing commitments and agreements may seem to place a certain amount of stability as to when money has to be repaid or refinanced, things can also change in a hurry, leaving the business scrambling for alternative sources of capital.

In the current recession, this sort of stuff happens everyday and its one of the more common calls I get from potential clients.

While each story is unique, the basic gist is that everything was rolling merrily along with the business when all of a sudden, for no reason, out of the blue, a source of third party business financing called their loans, cut back on credit lines, increased their rates, etc.

Most people believe this type of problem only happens to businesses that are scrambling for survival and/or are offside with their loan covenants.

Not true.

When the economy is on a nice growth trend, the unexpected is less likely to happen, but still can happen with no advanced warning. In more turbulent times, all bets are off with respect to financing stability for anyone leveraging their balance sheet.

So if leverage is going to be necessary, then management of same is also going to be required.

And prudent management would include things like 1) always keeping your commercial financing profile up to date and in order, 2) periodically assessing your alternatives in the market, 3) developing an emergency refinancing strategy that can be implemented quickly.

An alternative approach most commonly utilized is to do nothing and deal with things as they happen. And during the past few decades, this approach has worked pretty well for most businesses. When things do go a rye there can be some short term scrambling to develop an alternative course of action, but the outcome is rarely ever fatal.

It will be interesting to see how the passive approach works going forward. Capital markets are upside down globally. Each major financial incident sends shock waves through the market, potentially delivering financial leverage disarray to your door.

Ongoing management of leverage does take effort and consumes resources. In today’s capital markets its also becoming more of a necessary risk management activity that every business needs to consider.

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About the Author Brent Finlay