The Business Book

(Joyce) #1


Borrowing on credit cards can lead
to financial ruin. In 2007–08 many
homeowners borrowed on credit to pay
their mortgages, but had insufficient
income to meet loan repayments.

See also: Who bears the risk? 138–45 ■ Profit versus cash flow 152–53 ■
Maximize return on equity 155 ■ The private equity model 156–57


bust—leverage. This is a measure of
indebtedness, or the extent to which
people or companies finance their
future by borrowing money. Society
and business had ignored the
warning of UK historian Thomas
Fuller: “debt is the worst poverty.”
When high leverage is
widespread in the economy—as
occurs when lots of people borrow
large amounts of money—the
degree of debt can create a short-
term boom. But this often comes
at the cost of a subsequent bust.

Taking risks
The financial crisis of 2007–08 was
largely caused by high leverage.
Individuals borrowed large amounts
on credit cards and took out 100
percent mortgages, both against
inadequate levels of income. When
the debts could not be met and
house prices fell, huge numbers
of people defaulted on their debts.
The equally highly leveraged banks
stumbled; their problems were
made worse by the large-scale

use of complex financial products
(also based around leveraging),
and the financial system crashed.
Leverage carries similar risks
for businesses. During good times,
when demand is rising and profit
margins are high, borrowing capital
to finance extra growth may seem
an attractive means to boost profits.
But leaders often ignore the
increase in risk that accompanies
an increase in borrowings. Paying
back debt is not optional (unlike the
payment of dividends, for example).
Highly leveraged businesses can
suddenly find that their high levels
of debt are no longer serviced by
sales. The borrowings that had
driven profits can begin, instead,
to drive the company into severe
cash-flow problems.
Broadly speaking, it is wise to
restrict borrowings to around 25
to 35 percent of the total long-term
capital employed in the business.
Any higher than 50 percent is
regarded as carrying too high a risk
level for a normal business. After
all, while the directors need to aim
for maximum profits, they are also
responsible for the long-term health
of the business, together with
the welfare and security of staff,
customers, and suppliers. ■

The leveraged buy-out

In a leveraged buy-out, a
business is acquired by a
company or group of
individuals using a large
amount of borrowed money,
most often from bank loans or
bonds (interest-bearing loans
that are used to raise capital).
Typically, the buy-out may be
paid for with a ratio of around
90 percent debt to 10 percent
equity, and the assets for the
loans are those of the company
being acquired. In other words,
the theory is that the debt is
later repaid by money raised
from the acquired business.
Leveraged buy-out investment
companies are today known as
private-equity companies.
In the 1980s, leveraged
buy-outs became notorious,
as some acquirers used a
borrowing ratio level of 100
percent, and the interest
levels on debt repayment
were so large that cash flows
crashed and companies went
bankrupt. More recently, a
$2.85 billion leveraged buy-out
and subsequent restructure
was used to rescue struggling
US film-production giant
Metro-Goldwyn-Mayer (MGM).

When you combine
ignorance and leverage,
you get some pretty
interesting results.
Warren Buffett
US investor (1930 –)
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