How do businesses make money? They create a product or service which they exchange with their clients for money.
And of course for any business that noticeably figures out a great formula to do this, there are going to be plenty of people who want to get in on the action.
The result is new entrants into the market seeking to duplicate their success. But why should a copycat operation have the success which resulted from the superior thoughts, feelings, and actions of the passionate business owner and the team he has assembled to generate such notable results.
At such times, it is certainly a great idea to scale. But, where is all the money going to come from. Answer: “Wherever it is right now.”
Money is always available for a good idea which along with proven execution can generate a higher yield.
And if money can be had for a certain percentage rate and safely generate a safe return exceeding normal profits as well as the cost of principle and interest, it makes complete sense to borrow to get further ahead of copycats and provide the business for valuable exchange oneself.
This is what most businesses do. But, where does it stop? Nobody has a fool proof crystal ball. So, how does a business know it is going to secure future profits?
It’s a fact that every investment prospectus always indicate:
PAST PERFORMANCE IS NO GUARNANTEE OF FUTURE RESULTS.
So, what is the restraint from taking on too much debt so as not to stall out on debt payments and effectively drawing out all the “water” from the “debt well.”
There is no bright letter rule, but there is a simple methodology which is used to give a perspective for making this decision.
It’s the “Leverage Ratio.”
The leverage ratio is simply the amount of total debt divided by the amount of total equity.
Any company which has total equity which exceeds total equity has a leverage ratio which is less than 1.
This means that if they couldn’t otherwise service their debt, they would be able to convert their equity in part or in worse case in whole to pay off creditors.
Any company which has total debt exceeding total equity has a leverage ratio which is greater than 1.
This means that if the company lost its footing and couldn’t keep growing so as to cover its debt, it would not be able to cover its debt.
Ok, so this being the case how far do companies push their leverage ratio.
My understanding is that this is an industry specific question.
That said, most often companies don’t get much further “out beyond their skis” than a leverage ratio of 2.
In this case, theoretically if the company went belly up, creditors would get a return of 50 cents on each dollar of investment.
Now, here’s the interesting thing. Remember that not long ago I wrote a blog called Savings-to-Income Ratio [HERE].
In that post, I mentioned that consumer borrowing for a house was allowed to 45%.
So, why is it that a consumer who has a secured asset can only borrow up to 45% of its value, whereas companies can sometimes borrow up to twice its value?
The answer lies in the very fact that a consumer is “consuming” – i.e. using up or depleting resources – whereas a business is “producing” – i.e. generating valuable resources.
It’s axiomatic that without production there can not be any consumption.
And this is where we get to the most important point of all.
Is it the businesspersons who order the means of production so that we have goods and services to consume who is evil, or the person who sits around doing nothing which generates value while
“protesting” that businesses vacuously described as “the man” are evil?
It’s totally clear!
If you want to change the world. First, pull your own shit together and get out there and produce and do so to the point that you can help others to be productive too.
Focus on investing in yourself, no not beyond your ability to pay, but do invest in yourself to become more spiritually, mentally, emotionally, physically, and financially fit.
This then will allow you to have the influence to do good in the world and instead of being a net consumer, you’ll be able to step up and be a net producer.
A producer that others are willing to invest in. Whether you decide to take on the debt to accelerate your growth, well if it is a true investment in yourself with a strong, definable return …
Time is a wasting. And it is time, not money, which is your most valuable resource!
Have a great Friday and weekend ahead. Tomorrow, my post is going to be about “rigidity in space.” Hope you will return to view it. Cheers!