The latest joke in the industry is that by the end of next year, there will be more lenders than marketers. While obviously an exaggeration, there has definitely been a proliferation of lenders competing to fund your next project.
Unlike traditional loan-to-collateral value lenders, however, these new alternative lenders often offer to lend you more money than your project costs! When lenders fund 105% or 110% of a project, you may unknowingly find yourself in a high leverage position.
Leverage is defined as total company liabilities (including suppliers as well as loans) divided by total assets. Traditional banks prefer that total liabilities never exceed 75% of total assets. Why? To provide a cushion in hard times.
For marketers wanting high return on equity for investors, however, more leverage produces higher returns. For instance, if you must invest $100,000 of your own cash for a down payment on a project that returns $20,000 per year, your return is 20%. If you are only required to put $20,000 down and still get a $20,000 annual return, you’ve now made 100% on your money. Using this philosophy, the less invested in a project (higher leverage), the better the return, so why not use this strategy for every transaction?
The problem with leverage is not during good times, it’s during bad times. High leverage typically means high loan interest costs. If a company falls into lean times, (for instance, when gross margins get squeezed due to new competitors) that extra interest expense can cause bottom-line losses.
When losses occur, the cash to fund the ongoing operations must come from somewhere. Typically, marketers borrow more money which causes more interest expense. This cycle sends the company into a spiral of deeper and deeper debt.
From a balance sheet perspective, the difference between total liabilities and total assets is owner’s equity. When a company experiences losses, owner’s equity is depleted by the amount of the loss. A company with high leverage has a very small equity position with very limited ability to absorb losses.
Think back to our project example. Let’s assume a marketer creates a brand new company for this project and invests the $100,000 down payment. Instead of making $20,000 the first year, however, he loses $20,000. Because the marketer invested $100,000 up front, he could withstand losses of this magnitude for five years before his initial funds would be entirely depleted.
Now let’s take the example of the $20,000 down payment. Remember, that’s the one that produced that great 100% return on equity. Now, if the same $20,000 loss occurs, that marketer is out of money and completely broke. He must put more cash into the company or close it down.
At Meridian, we highly recommend 75% financing to keep you out of leverage problems. Yes, it’s conservative, but we want you to stay in business and continue to be our loyal customer in another ten years!