Leverage in a Business - Essay Example

Leverage in a business: The term leverage is derived from the word lever which is essentially a tool, that aids to lift the loads depending upon the distance between the load and the point of application of force. The greater this distance, the more load can be lifted. Leverage in a business is depicted by the debt to equity ratio of that business. The larger this ratio, the more leveraged the business is considered to be. The philosophy is fairly simple and reasonable. Any business requires investment in order to make revenues.

In order to maximize the profits, it is imperative that the investment is enlarged. There are two fundamental ways of increasing the investment amount: 1. By selling the company’s stock. 2. By getting the loan. Both options have their own merits and demerits. If money to be invested is gained by selling the company’s stock, it is equivalent to sharing the company’s ownership with the stockholders. In this method, the profits earned on the initial investment are essentially divided between all the stockholders and the original owners as per their share in the company’s ownership.

This brings little advantage to the owners as they are only entitled to the profits earned on their share of the investment. Also, such investment is considered to be equity and is non-tax-deductable. Hence, the taxes imposed on the equity are enlarged. Therefore, corporate businesses are more tempted to get the loans to build the required investment. In this case, the loan lenders need to be paid a pre-established interest on regular intervals until the principal amount is returned. This option brings additional benefits for the businessmen because they are the sole owners of all revenues earned on the investment, so they can return the principal loan as per their convenience.

Moreover, the loan serves to reduce the total amount of taxes implied. The larger the loans borrowed for a business, the more leveraged it becomes, because the loan is similar in function to the distance between the load and the point of application of force in a lever as discussed above. Similarly, “import tariff reductions tend to increase leverage while export tariff reductions tend to decrease leverage.” (Baggs and Brander, 2006). It is noteworthy that it is never essential that the business will always succeed in making profits, it may incur losses as well.

This means that irrespective of whether the business makes profits or incurs losses, their amount is directly proportional to the amount of loan borrowed for the investment. Hence, leverage in a business can be thought of as risk in a business, which may bring either opportunities (profits) or failures (losses). Similarly for a stockholder, the amount of profits or losses made on the stock is directly proportional to the extent to which the company is leveraged. Conclusion: Getting a loan to start a business is like buying a business, and there is always a right and a wrong approach towards buying a business which decides the results of investment.

(Taylor, 2009). For experienced owners with business in regions having a stable economy and market trends, it is always advisable to make the business more leveraged, in order to make greater profits and pay minimum taxes. References: Baggs, J. and Brander, J. A., (2006). Trade liberalization, profitability, and financial leverage. Journal of International Business Studies. 37, 196–211. doi:10.1057/palgrave.jibs.8400183. Taylor, B., (2009, Nov. 4). Buying a Business Instead of Starting One.

The New York Times. Retrieved from http://boss.blogs.nytimes.com/2009/11/04/buying-a-business-instead-of-starting-one/.