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UNDERSTANDING THE USE OF LEVERAGE AND ITS RELATIONSHIP TO PROFITABILITY AND LOSS



 
 
 

Financial Leverage is financing a company with other people's money.

Benefits: (profitability) The return for the entrepreneur can be greater because his/her money is not tied to the business. With a highly leveraged business the owner equity is small, as the debt is paid the return can yield a very high Profitability ratio.

Deficits: (loss) In order to pay the interest on the leverage, the owner may have to raise prices, in a highly competitive market, this may result in lower sales. If the competition is Equity Financed they may be able to lower prices, resulting in a LOSS or even bankruptcy.
 
 

Fixed Costs are interest paid on the debt(s).

Leverage works like a seesaw:


A small business can use leverage to balance a large amount of assets. This way the small business can compete with much larger competition. The fulcrum point being the debt and the distance away from the business is the fixed costs of the debt. As the fixed costs increase, the fulcrum point is moved closer and closer to the business, making it harder to maintain the weight of the increased assets.



The use of leverage depends on the needs of the company, sometimes it is a desirable situation and sometimes in can burden the business into failure. While using leverage it is recommended to manage your debt very closely, use creative ways to increase sales and to put your money or Equity into something more profitable than the cost of the financing.
 
 

Example:
 In order for me to remain competitive in my Rodney's Nuclear Arms Trading Co. I would need to have a new reactor. Since I do not have the money available I would go to the bank with my plan and seek a loan. Once I receive the loan I am now FINANCIALLY LEVERAGED, although without the LEVERAGE I would no longer have been competitive and would have lost money.
 
 
 
 
 
 
 
 
 

 
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