In my last post, I started talking about the role that debt has in a business. To recap: for a business, debt is your leverage and helps you to grow.
When you look at your financial statements, you’ll see your debts presented as liabilities on the Balance Sheet. Debts that come due within one year are listed as short-term liabilities. In other words, these are liabilities that are part of your Operating Cycle and include your day-to-day expenses. Liabilities that last longer than one year are called long-term liabilities and take place in the Asset Cycle.
Why is it called the Balance Sheet? The name is meant to bring to mind the image of a scale that keeps two things in balance. Liabilities are placed on the right-hand side of the scale and are balanced out by assets on the left-hand side. (Your Balance Sheet will probably put these on top of each other, rather than side-by-side. I’m going to keep talking here in terms of balancing those scales).
Every liability is tied to an asset. For instance, when you take out a loan to purchase a vehicle, you may put some of your own money down (in other words, some of your equity). However, the majority of the purchase is done on credit.
Let’s say you bought a truck for $50,000 and paid $5,000 out of pocket. The left-hand side of your balance sheet will show $5,000 less in cash, but you will have gained a $50,000 vehicle listed as an asset. On the right-hand side of the balance sheet is the $45,000 loan for the asset. You will notice that $50,000 minus $45,000 equals $5,000. In this case, you have less cash, but the same amount of equity. In other words, your company’s net worth is the same as it was before you made the purchase. How? The cost of the loan (the value of the liability) is canceled by the value of truck. The asset and liability cancel each other out. Furthermore, notice how your company expanded – its total assets grew even as your net assets stayed the same. That’s what leverage is about.
Another way to think about business debt is to use the terms Sources and Uses of debt. These concepts can help you picture how to use debt properly and remember the “why” of the debt in your business.
In our example, the truck loan was a Source of debt and the purchase of the truck was the Use of that debt. Purchasing a vehicle was meant to help grow your business—perhaps to make deliveries or have for your employees travel to remote worksites so you can serve more customers. The Sources and Uses concept easily applies to other assets you might acquire through debt: equipment, raw materials, inventory etc.
The main point is to remember that your liabilities match against assets that match against your increased output.
Next time, I’ll talk about how you can measure that increased output from your leverage.