Financial leverage

August 1, 2012 By    

Often the goal of the independent business owner is to attain a level of success achieved by growing the business to a point in which the company becomes debt free. Congratulations if you have reached this debt-free goal with your propane company.

However, I would argue that should you reach the debt-free level, you are underperforming from a shareholder-return standpoint and therefore underutilizing the shareholder capital that has been entrusted to your care.

Consider for a moment the fact that most public companies carry a certain level of debt as a normal course of business. The questions become: Why do this and what purpose can it serve? The answer lies in the principles of the efficient use of equity capital and debt capital to maximize shareholder returns. These same principles can and should be put to work for your business, as well.

Financial leverage as a tool
Financial leverage results from using debt to finance assets. The greater the ratio of funds contributed by creditors compared to funds contributed by stockholders, the greater a firm’s financial leverage. Simply, financial leverage magnifies changes in net income compared to changes in operating income. Below is a simple example of financial leverage applied to an application in a retail propane situation.

Let’s assume that a new propane installation opportunity will require a $10,000 investment. This installation will annually consume 10,000 gallons and produce $4,000 of net profit (assuming gross profit, operating expenses and operating income of $1, $.60 and $.40 per gallon, respectively). For the debt example, we will assume that 50 percent of the investment was borrowed at a rate of 5 percent, for an annual interest cost of $250.

Example of Financial Leverage
Without debt With 50% debt
Equity invested $10,000 $5,000
Operating income $4,000 $4,000
Interest cost @5% 0 $250
Net income $4,000 $3,750
Return on equity 40% 75%

 

In this example, funding the investment from the owner’s equity equates to a very nice 40 percent return. Of course, when you apply debt for half of the investment, the net income goes down by the amount of the interest cost ($4,000 less $250 = $3,750).

Several things are at work in the process that I believe are crucial to understanding the use of financial leverage. First, in this example, the amount of equity invested is reduced by half, which is an excellent example of the efficient use of capital, while still achieving the investment goal. Secondly, borrowed capital is being deployed at a cost of 5 percent toward an investment, producing 40 percent returns and creating an incredible spread. The leverage is applied, creating 75 percent net return on equity invested. The net effect is to allow for the excess equity capital to be deployed elsewhere while the equity that is deployed receives an almost double return.

This oversimplified example ignores a number of issues that complicate the math, such as the tax implications and the term of the debt. However, the concept and application of leverage work in a more complicated real-world model that includes these items.

An outside-in look
Looking at this another way, consider that you are an outside investor looking into this operation. Which investment would you then make – with debt or without? Why would you settle for a lower return when the higher return is easily available? How would this comparison look year after year with compounded effects? Where would your investment dollars gravitate?

Now as the leader of the business and manager of the company’s shareholder equity capital, why should you not consider the return on shareholder equity just as if you were on the outside looking into a new investment? Are you not underperforming, just as in this example? Is your equity capital being maximized?

I would never advocate becoming overleveraged or taking on debt that could not be serviced handily in stressed case scenarios. However, the concept of measuring and maximizing return on equity for independent propane operators is seldom discussed.

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Kevin Yanik

About the Author:

Kevin Yanik is the senior editor of LP Gas Magazine. Contact him at kyanik@northcoastmedia.net or 216-706-3724.

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