Debt Leverage

Question

Understanding  and properly utilizing debt is not only a key to success in business,  it is a key to success in life.  Debt, also referred to as leverage, can  be both a valuable tool and a recipe for disaster.  Describe scenarios  with both a proper use of debt and an inproper use of debt.  Please be  specific as well as realistic.  Don’t describe a scenario that wouldn’t  be possible in today’s environment (in other words, the days of no doc  mortgages where you are given a loan without revealing your income or  other personal information are over).

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“Leverage uses those items having a fixed cost that magnifies the  return to a company. These fixed costs can either be related to company  operations (operating leverage) or directly related to the costs of  financing (financial leverage). Operating leverage deals with the fixed  costs of assets, and are shown on the income statement as leases,  depreciation, executive salaries, property taxes, and so on. Financial  leverage deals with the fixed costs of financing, such as the amount of  interest a company pays on debt.” (Adelman, 2014, p. 138) Assets such as  delivery trucks, onsite equipment such as excavators, and personnel  lifts can enable a company to produce more and in turn yield profit. If a  company overextends itself attaining assets, and  improperly(excessively) used credit to attain those assets then that is a  swing in the wrong direction regarding the balance of debt and assets  with leverage and could become too much of a liability for a company.

The purchase of a car has other benefits which are necessary and may  not have a financial return and is not technically viable from a  financial perspective. The purchase of a car would more reasonably not  be expected to be a financial return since cars lose thousands of  dollars in equity the moment, they’re driven off the lot and drop  exponentially in value from there. The upside to that is that alternate  benefits to the owner may yield financial returns via alternate routes  such as the ability to drive to work. Some people do by cars from places  like Florida to turn them around and sell them in the North East for a  profit, but that is less common than the normal car purchase. However,  that example turns a considerable amount of profit and does sound  feasible.

An example of the use of proper debt leverage is having more equity  than debt and meeting the lender’s requirements of being between 43-36%  debt-equity-ratio and qualify for a home loan. Here are three highlights  regarding the proper use of debt. “Good debt has the potential to  increase your net worth or enhance your life in an important way. Bad  debt involves borrowing money to purchase rapidly depreciating assets or  only for the purpose of consumption. Determining whether a debt is good  or bad sometimes depends on an individual’s financial situation,  including how much they can afford to lose.” (Smith, 2021)

References

Adelman, P., Marks, A. (2014). Entrepreneurial Finance, 6th Ed. Pearson Education, Inc. New Jersey.

Smith, L. (2021). Good Debt vs. Bad Debt: What’s the Difference? Investopedia. Retrieved from https://www.investopedia.com/articles/pf/12/good-debt-bad-debt.asp

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