How to understand the "leverage principle" in business?
This article introduces the "leverage principle" in business, including financial leverage and control leverage. Financial leverage refers to using a small amount of money to make a large investment, while control leverage refers to using a small share to control large assets. The article also discusses different types of debt financing and the interest rates and advantages of operating leverage. Finally, the article mentions two common ways in which entrepreneurs establish control leverage.
- The leverage principle in business can be achieved through financial leverage and control leverage.
- Debt financing and operating leverage both have interest rates and require the investment return of assets to be higher than the interest rate of debt.
- Companies can achieve control and growth of assets through financial leverage and the establishment of control leverage.
The famous quote by Archimedes, "Give me a lever long enough and a fulcrum on which to place it, and I shall move the world," refers to the principle of leverage. He was able to say this because he knew that by increasing the length of the lever arm, he could amplify his own strength to lift the weight of the world.
By further abstracting the principle of leverage from physics, we can consider any practice of using a small amount to achieve a larger outcome as utilizing leverage.
In the economic and business fields, there are two types of leverage:
- Financial leverage, which involves using a small amount of money to make a large investment.
- Control leverage, which involves using a small share to control large assets.
Debt financing can be both financial leverage and control leverage.
When a company wants to undertake a construction project, in addition to equity investment from shareholders, it can also obtain debt financing by borrowing from banks or selling bonds in the capital market.
There are two differences between debt and equity:
- First, debt has a priority right to enjoy investment returns compared to equity. After debt repayment, equity investors can begin to receive dividends. If the debt is not cleared, shareholders cannot receive any returns.
- Second, due to the priority of cash flow, the return on debt investment is limited and fixed by the debt contract. This is why it is also called fixed-income investment, while the return on equity investment is unlimited.
Contrary to the order of cash flow rights, in terms of control, when a company is operating normally, creditors have limited ability to intervene in the company, while equity investors have ultimate control.
Debt creates leverage for two reasons:
- First, equity can obtain control of the entire asset with a small portion of financing. This allows for a small investment to achieve a larger outcome.
- Second, the existence of debt amplifies the volatility of equity returns. If the asset's return is good, equity returns will be higher. If the asset's return is poor, equity returns will suffer.
Comparing equity and debt, it is clear that for the same construction project, equity investment is more controlling and carries greater financial risk, resulting in a higher expected return rate. On the other hand, debt investment is more passive and carries relatively lower financial risk, resulting in a lower expected return rate.
A company's debt financing does not necessarily have to come from banks or the capital market; it can also come from customers, suppliers, or even employees.
Debt obtained from financial institutions or the capital market is called financial leverage, while debt obtained from customers or suppliers is called operating leverage.
For example, in the Chinese real estate industry, approximately half of the debt financing is financial, while the other half is operational.
Customers lend money to companies because of the pre-sale system for houses. The houses are sold to consumers before they are built, so the companies use the consumers' money to construct the buildings.
Suppliers lend money to developers through credit transactions. Suppliers are often required to advance all material and labor costs when accepting orders, and the debt is only settled after the real estate company sells the houses.
All debts have interest. Money borrowed from banks or the capital market has a clearly stated interest rate and repayment schedule.
The interest rate of operating leverage is often implicit rather than explicit.
For example, pre-sold properties may have a discount compared to ready-to-move-in properties, and this discount can be considered an implicit interest rate. Suppliers may offer more favorable prices because they have provided advance funding. These advantages in price or competitiveness are also considered implicit interest rates. The most important consideration when using leverage is to ensure that the investment return rate of assets is higher than the interest rate of debt. Only in this case can leverage contribute positively to the investment return rate.
If the investment return rate of assets is lower than the interest rate of leverage, the leverage will have a negative effect. If the two are equal, leverage will have no effect.
So, which type of leverage should a company use? Financial or operational? If operational, should the company obtain more financing from customers or suppliers?
To answer these questions, companies generally need to consider two aspects:
- Financing costs: Companies can calculate the explicit or implicit interest rates of various debt financing options and compare their costs.
- Operational stability: Unlike bank loans, when companies receive prepayments from customers, it is both a financing activity and a way to secure customers, providing greater predictability of income.
By obtaining advance funding from suppliers, companies can control the delivery time and quality of products.
Therefore, the analysis of financial leverage is relatively simple, while operational leverage requires consideration of many operational issues.
Based on the different characteristics of equity and debt, different assets require different financing methods.
For example, for start-up companies with high uncertainty and no stable cash flow to repay debt, equity financing is generally the only option, and it is difficult to obtain debt financing. Investors must share the risk with the founders.
However, for mature companies with limited growth potential, equity investment may not be attractive to investors, but debt financing is suitable because there is a stable cash flow to repay debt. In this case, debt investors bear minimal risk, and the majority of the risk is concentrated on equity owners.
For growth-oriented companies between start-ups and mature companies, both equity financing and debt financing have their place. In this case, optimistic individuals invest in equity, while conservative or pessimistic individuals invest in debt.
It is evident that equity investment has unique significance.
Overall, when the stock market is more prosperous than the bond market, investors are generally optimistic. When the bond market is more prosperous than the stock market, investors are generally cautious.
When the stock market is not growing but government debt is rapidly increasing, it indicates overall pessimism among private investors. In this case, the government needs to inject demand through economic stimulus and instill confidence in the market, which is in high demand.
In all countries, the government is always the ultimate controller of the economy, the ultimate risk manager, and the ultimate source of confidence.
However, the government's confidence must be able to drive market confidence for the economy to function properly. If the government expresses confidence but fails to convince the market, it indicates significant structural problems in the economy.
The previous analysis focused on financial leverage. In the economic and business fields, another type of leverage that involves achieving more with less revolves around control.
For entrepreneurs, the ability to control a large amount of assets with a small amount of capital is often an important consideration in management.
Entrepreneurs are attracted to control for both positive and negative reasons. The former is often because entrepreneurs have grand ideals, and strong control can help them achieve these ideals. The latter is often because entrepreneurs want to gain greater personal benefits through control.
As mentioned earlier, this control can be achieved through financial leverage. However, financial leverage amplifies financial risks along with control, so it is not always the best choice.
If entrepreneurs do not want to amplify financial risks, a common practice is to establish a pyramid-like organizational structure through the establishment of holding subsidiaries:
At the top of the pyramid is a group company in which the entrepreneur holds a large share. Below the group company are a series of subsidiary companies in which the group company holds a large share. Below the subsidiary companies can be another layer of subsidiary companies in which the previous layer holds a large share, and so on. In this way, the entrepreneur at the top of the pyramid can control a large amount of assets with a small amount of capital.
Another way to establish control leverage is to utilize unique regulations in certain countries or regions worldwide. This involves creating a share structure with different rights but the same shares. The entrepreneur invests a small amount of capital to purchase controlling shares with excessive voting rights, while other investors can only buy ordinary shares with cash flow rights but inferior voting rights.
The core of both of these methods is to attract other equity investors who do not have a desire for control.
In fact, this kind of cooperative relationship does not necessarily have to be fixed in the form of equity. Companies can also establish alliances through contracts and other companies while maintaining maximum relative control within the alliance.
The relationship between Apple and its app developer ecosystem is an example of this; the relationship between Google and the Android ecosystem is also an example. The relationship between the United States and the International Monetary Fund or the North Atlantic Treaty Organization is also an example.
Regardless of the specific method used to amplify control, it is clear that control always comes with costs.
If the center of the system wants others to follow, it must provide benefits to followers using its own resources. If these benefits are not attractive enough, followers may leave the alliance or sell their shares.
If followers cannot sell their shares due to various restrictions, the friction between the two parties will generate enough negative effects to devalue the controlled assets. As a result, the control center will pay the price of selling assets at a discount during the next round of financing.
Whether it is financial leverage or control leverage, in the absence of deception or information asymmetry, the core resource that enables leveraging is the ability of the entrepreneur.
Leverage amplifies the ability of the entrepreneur.
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