How Debt Can Generate Income | Leverage Explained

In this video, let's talk about debt. In life, every one of us is going to face it. As an individual, it's important to understand when debt may be necessary to get us what we need. As an entrepreneur, it's critical to understand leverage and what it means for your business. This is a very important topic for everyone. So don't skip it. First, what's debt? According to Wikipedia, debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. 

It's actually not a modern invention. It goes back as early as 3,500 BC when people used clay tablets as a record of a future obligation to pay. Nowadays, we use other forms of written contracts, but the concept of debt is the same. And you probably also heard about good debt versus bad debt. What calls good debt is debt that helps us build wealth. This means when we spend the money on things that generate more income than we pay interest. 

For example, let's see you get a $100,000 loan for which you going to end up paying 4% interest annually. If you can invest that money and get back a return of 7%, you make a profit of 3%. So after one year, you're going to have increased your wealth by $3,000. As long as the interest rate doesn't outpace the level of return, taking on debt is a good idea. Getting a loan to buy a car can also be a good debt. If you can't get to work otherwise or do your business otherwise.

So what's bad debt then? Well, that's that that reduces your wealth. Basically, it's buying stuff you don't really need or stuff that doesn't create income with money you don't have. So getting that brand new iPhone phone, that TV, or the luxury vacation on credit because you can't really afford it right now is a bad idea. Other than pleasure, this kind of debt doesn't give any other returns. Especially if you put these purchases on your credit card, you're going to end up paying high-interest rates if you don't pay off your monthly balance. 

We're talking about 14, 15%, and even more. So for consumer goods like this, decide for yourself if it's really necessary and only buy it when you saved enough and you can afford it. But what about businesses and the role of debt there? Most businesses need some assets to provide their customers with goods and services. These assets usually cost money and buying these assets needs to somehow be financed. The money can come from the owners of the business, in which case, equity is put into the business. 

But most of the time, the money owners can put into the business isn't enough, and the business needs to get external financing like a bank loan. The same principles for good and bad debt apply here, too. As long as the investment of businesses using the money for is generating more return than its paying interest is good debt because it's increasing the wealth. And of course, the opposite is bad debt. 

Now let me show you how taking on debt or financial leverage can be a good way to grow a business faster. But before we get to that, though, look to see if you're subscribed to this channel. If you aren't and you like what consider subscribing. Let's say you want to operate a lemonade stand. Now we're going to keep this simple and we're going to assume we don't have any tax effects here. So you're going to put $100 of your own money as equity into the business to buy the required assets you need, like the stand, the equipment, and the inventory that you need to make that lemonade. 

This is all the money you have. So you're super excited, you want to make it work. And it works. You earned a profit of $10. This means you earned $10 on your investment of $100. In business terms, it means your return on equity is 10%. It's not bad, right? In fact, because you got a good return, you want to grow the business. Growing the business in this example means running a second lemonade stand with another $100 investment. Now, you have two options. 

You could either wait until you make enough cash from the first stand to finance another stand with your own money, and that's called bootstrapping. Or you could go to the bank and get a loan for $100. This means you're going to take on debt. You go with the loan option because you see an opportunity to grow and you don't want to wait that long. Obviously, the bank will charge interest for the loan that they're going to give you, so let's say they charge you 4%. 

So you're going to incur an interest expense of $4 for the second lemonade stand. The operating profit of the second stand is also $10. So when you deduct interest expense, you make a net income of $6. Together with the first stand, this means you now make $16. The equity, which is your own money that you put into the business, still is only $100. This means now that they improve your return on equity to 16%. Working with other people's money improved your ROE, your return on equity. Because business is great and you want to grow further, you again go to the bank to get another loan, another $100 for 4% interest. 

The third stand makes the same profit as the first two. You make another $10 with it, minus the interest expense of $4, which gets you a net income of $6. Together with the other two stands, you now make a profit of $22 on your $100 investment. The return on equity is 22%. By taking advantage of the leverage effect, you manage to more than double your ROE. This is great, right? So of course you go back to the bank, you open more stands, and just keep making more and more money. 

Soon you end up operating six stands with an ROE of 40%. Life is grand. Is it really that simple, though? What's stopping you from taking on more debts, buying more stands, and just growing and growing? Well, there are a few reasons this can't go on like that. Number one, while leverage can help a business make money faster, you have to be aware that debt always carries risks. After the sixth stand, the business has loans of $500 on its balance sheet. And at some point, it's going to have to pay back this debt. Right now, the business is profitable, but what happens when it's a rainy summer and demand for your lemonade is low? What if you need to go on lockdown? Will you even make enough profit to pay for that loan? So a highly leveraged company always poses a higher risk.

 And that brings me to number two. Because we will consider your highly leveraged business at higher risk, banks will be reluctant to open additional credit lines to help you grow. And even if you get the additional loans, your most likely going to pay a higher interest rate because the bank is going to want to earn more for taking on a riskier loan with you. The interest rate will probably not stay at 4%. This makes the loan more expensive, and it's going to reduce your profit margin. So let's just say the bank offers you a revised interest rate of 7% for funding $500 for you to open your six stands.

 Suddenly, face an additional interest expense of $15 which reduces your net income to 25. Your ROE just got reduced to 25%, but this is still better than just one stand financed with equity, which gives you 10%, right? Great, but let's say another entrepreneur comes along and opens a lemonade stand next to yours because they realize that you're onto something. But she's quite experienced, and she already operates a bunch of other stands across town and across cities, across the globe. Because of the higher volumes, she gets better prices for the lemons and oranges. 

So she can be more aggressive in the pricing of her lemonade. To not lose business, reduce your prices. And suddenly, your stands don't make an operating profit of $10 anymore, just $2. Let's see how this affects your business. If you still only had one stand, fully financed with equity, you'd still be okay, right? Your ROE would be 2% on the $100 investment. Not great, but it's still better than what you get from a savings account. But you took on a lot of debts to finance your growth. 

So now, for the additional five lemonade stands, financed with bank loans, you have interest expenses to pay that is higher than your profits. Remember, the operating profit is only $2% now. And with a 7% interest rate for the $100 loan, pay $7 interest, leaving you with a loss of $5 for each of these five externally financed stands. And that's not where it ends because of the lack of profits. You don't generate cash. So you can't even pay back that interest. Finance the loss with more loans to even stay solvent. This will not continue like that for long, and soon your lemonade business is going to be history. 

To summarize, leverage allows companies to earn income from assets they wouldn't normally be able to afford. So in good times, it can help you grow faster. It can multiply every dollar of your own money that you put into the business. But in bad times, it can also leverage your losses and puts the business at risk to go down just as fast. I hope this video was helpful in understanding debt and financial leverage better. As always, if you like this video, don't forget to give it a thumbs up.

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