Debt is a topic that gets people fired up. It can make you money. It should be avoided like the plague. Classic good vs. evil arguments. To me, it is just another tool that you can use. From a business standpoint, it is very important to understand the impacts of debt and why it is called leverage.
Look at the table below. It represents two scenarios – one where a company is making money, and another where the company is losing money. I want to focus on ROA – Return on Assets, and ROE – Return on Equity. If there is no debt, they are both the same. But with debt, someone else owns a part of your company, and the amount of equity you have invested is less. When you borrow money and have a good year, your ROE grows substantially more than the ROA. In the example below, the difference is 20% ROA and 100% ROE. Borrowing money allows you to make a substantially higher return on your portion of the money invested in the business.
Now for the other side of the coin. What happens if you have a bad year? In the second column, you see a company with 1 million in sales lost $50,000. That’s a shortfall of 5% of total sales, and I have seen folks argue that is not much in the grand scheme of things. But look at the ROA. That $50,000 loss translates to a 10% loss in total assets. And when you look at equity, that amounts to 50% of your equity in the business.
Leverage works both ways. With debt, if you are making money, your equity grows much faster than without debt. If you are losing money, your equity disappears much faster too.
The bottom line is, debt is an accelerator. Make sure you know the direction you are traveling before stepping on the gas.
|Making Money||Losing Money|
|Sales||$ 1,000,000||$ 1,000,000|
|COGS||$ 400,000||$ 600,000|
|Gross Sales||$ 600,000||$ 400,000|
|Total Expenses||$ 500,000||$ 450,000|
|Net Income||$ 100,000||$ (50,000)|
|Assets||$ 500,000||$ 500,000|
|Liabilities||$ 400,000||$ 400,000|
|Equity||$ 100,000||$ 100,000|
|Equity AFTER Net Income or loss||$ 200,000||$ 50,000|