This is article 1 in the ‘Renegade Leverage’ series of articles which discuss key points of leverage available in every small business that, when acted upon, can grow your business exponentially.
- It’s easier to grow your business with leverage
In this first article, we will discuss how gearing can be used to rapidly grow (or destroy) your business. The word ‘gearing’ has many definitions but in this article I will define it as ‘the ratio of your capital versus other peoples capital in your business’.
Using other peoples capital to grow your business is an important strategy because it enables you to grow your business more rapidly than if you have to finance your business using just your own resources.
Key sources of capital other than your own are investors, bank overdafts and loans, government grants and credit offered by your suppliers.
Each source of of capital is looking for a ‘return’ for financing your business. The investor requires dividends and capital growth in the share price, the bank requires interest and fees, the government wants employment creation and the suppliers want to supply your business with their products and services so they can earn a profit margin.
These sources of capital are taking a risk that they will not receive a return on their capital. The risks of investing in your business are reduced by the amount of capital you have accumulated in your business versus the amount of capital they have invested. Generally the higher the risk the higher the return expected i.e. an unsecured creditor expects a higher return than a secured bank.
The lower the gearing, the lower the risk of loss but the growth of the business may be slower (provided the additional capital can be used profitably).
For example, in banking, as a rule of thumb, the banker requires that you have £100 of your own capital invested for every £100 of borrowing i.e. gearing is 1:1 or 100%. This means that only if your capital of £100 is lost is the banks £100 at risk i.e. your capital is the buffer of safety for other peoples capital.
In banking, the gearing ratios change depending on the type of business and security available. For example, on property the bank is often willing to lend 80% of the value of a property i.e. gearing of 4:1 or 400% (On a property valued at £100,000, your deposit is £20,000 and the bank mortgage is £80,000.) This ratio means that the property has to lose £20,000 of value, or the debt increase by £20,000 due to unpaid interest, before the bank loses a penny.
So lets look briefly at an example of how gearing can rapidly grow your business and capital. Using property investment as the example again. If you put a £20,000 deposit down on a £100,000 property and that property increases in value by £20,000 then you receive a return of 100% on your capital in addition to any excess of your rent over the financing and property maintenance costs. (Compare that to the interest return by keeping your cash in a bank deposit account.)
In a rising property market where you can rent to cover your financing and maintenance costs, it is easy to make money because the £20,000 rise in property value can also be used to secure another loan to buy another property. This is how large property fortunes have been built.
However in 2008, after a run of 12 years in a rising market, the property market crashed and property investors and banks were in trouble almost overnight – their margin of safety was gone and they were looking for a reduction in their lendings, more security and a higher interest margin to reflect the increased risks.
Unlike the recession of the 1990′s, interest rates have remained low and investors have been given a breathing space to degear to put their house in order – nevertheless the outlook for many highly geared property investors looks uncertain at best. This amply demonstrates the risk of high gearing.
So increasing your gearing is sensible where there is a good prospect of generating a return well in excess of the cost of borrowing the capital. Where the return is uncertain or marginal then using other peoples money to grow your business will be more difficult and risky for both parties. At the very least outside investors will want to ensure that you are fully committed to the enterprise.
The business owner therefore has to weigh the risks versus the rewards of using other peoples money but the rewards can be huge in the right circumstances and ‘gearing up’ is a key growth strategy for many businesses. If you want to ‘gear up’ for success you may need a business plan to persuade other people to invest in your business. You may want to take a look at my business planning pages?
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