Unclouding the conventional view on leverage

Leverage: oft misunderstood, intensely mistrusted, publicly reviled, privately coveted.

Leverage: creator of wealth, cancer of markets, destroyer of nations.

Or is it?

Saying that leverage is bad is akin to saying that speed is bad. It is true in both cases that too much of either is dangerous. What is misunderstood is that too little of either is dangerous as well.

A simple example is driving at 30 kph on a highway. If the rest of the traffic is moving close to the speed limit, say 100 kph, then the car being driven at 30 kph is a threat to its own safety as well as the safety of others. That is why there is a minimum speed limit on highways.

Moving on to leverage, it is simply a measure of the ratio of debt to equity.

This link between debt and equity is critical. Debt is an absolute number – saying that a company has US$1 million of debt does not really give any insight on whether this is a lot or a little. If the company had $100m of equity then the debt does not seem to be a big deal. On the other hand, if the company only had $10,000 of equity then the debt level would be alarming.

As always, life is not about minimising any one risk, but about managing it and ensuring that you benefit appropriately for the risks taken. We go back to the foundation of leverage: managing cash flow mismatches. The cash conversion cycle is rarely 0 days, and the gap between cash outflows to suppliers to produce the product or service and cash inflows from customers needs to be funded. This is working capital financing. Without it no company can function.

The real value of leverage comes in the form of growth funding. To fulfil their potential, companies need growth capital.

The classic company needs to acquire physical assets and service companies need to hire and train talent and then pay their expensive compensation before they can acquire clients and generate cash inflows.

The mistake many companies make is to fund 100 per cent of this using equity. The thinking is that equity is far less risky, in that there is no maturity date when it needs to be repaid. The assumption is that there is no cost to the equity, when in reality there is a high cost to the equity, due to its illiquidity and junior position in terms of claims on the company’s future cash flows.

So how does the cost of equity manifest itself? The first is shareholder demands for dividends. The second way is by the share price. You see, a return is composed of a payout by the company, for example the dividends, divided by the rise in price of the shares. If the company refuses or is unable to increase dividends, then the market will adjust by dropping the price of the shares.

In efficient markets the lack of a market equity return will get the board and management fired. Markets that remain inefficient through a faulty understanding of the cost of capital will have companies whose capital structure is viewed as inefficient by foreign investors. Relatively low equity returns will put off foreign investment, and no amount of changes in regulation will help attract it.

What can be done to improve the situation?

First is to make it more palatable for companies to borrow not least by banning the use of security cheques by lenders. The threat of getting fired for low returns on equity pales in comparison to the threat of prison.

Second is to encourage alternative lenders into the market. Bankruptcy regulation is just as important to higher yield lenders as it is to borrowers. Alternative lenders with the skill and appetite to fill the massive gap left in the capital structure of companies by equity shareholders at one end and commercial banks at the other will do more to attract foreign investment than any other avenue.

The supply of credit more in line with the needs of the market will allow companies to build a more competitive capital structure, one that not only attracts foreign capital but also allows companies to more easily expand regionally and internationally.

Sabah Al Binali is an active investor and entrepreneurial leader. You can read more of his thoughts at al-binali.com.

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