Page 153 - (DK) The Business Book

MAKING MONEY WORK 151

See also: Who bears the risk? 138–45 ■ Profit versus cash flow 152–53 ■ The leveraged buy-out
Maximize return on equity 155 ■ The private equity model 156–57
In a leveraged buy-out, a
business is acquired by a
company or group of
individuals using a large
amount of borrowed money,
most often from bank loans or
bonds (interest-bearing loans
that are used to raise capital).
Typically, the buy-out may be
paid for with a ratio of around
90 percent debt to 10 percent
equity, and the assets for the
loans are those of the company
being acquired. In other words,
the theory is that the debt is
later repaid by money raised
from the acquired business.
Borrowing on credit cards can lead use of complex financial products Leveraged buy-out investment
to financial ruin. In 2007–08 many (also based around leveraging),
homeowners borrowed on credit to pay and the financial system crashed. companies are today known as
their mortgages, but had insufficient Leverage carries similar risks private-equity companies.
income to meet loan repayments. In the 1980s, leveraged
for businesses. During good times, buy-outs became notorious,
when demand is rising and profit as some acquirers used a
bust—leverage. This is a measure of margins are high, borrowing capital borrowing ratio level of 100
indebtedness, or the extent to which to finance extra growth may seem percent, and the interest
people or companies finance their an attractive means to boost profits. levels on debt repayment
future by borrowing money. Society But leaders often ignore the were so large that cash flows
and business had ignored the increase in risk that accompanies crashed and companies went
warning of UK historian Thomas an increase in borrowings. Paying bankrupt. More recently, a
Fuller: “debt is the worst poverty.” back debt is not optional (unlike the $2.85 billion leveraged buy-out
and subsequent restructure
When high leverage is payment of dividends, for example).
was used to rescue struggling
widespread in the economy—as Highly leveraged businesses can
US film-production giant
occurs when lots of people borrow suddenly find that their high levels
Metro-Goldwyn-Mayer (MGM).
large amounts of money—the of debt are no longer serviced by
degree of debt can create a short- sales. The borrowings that had
term boom. But this often comes driven profits can begin, instead,
at the cost of a subsequent bust. to drive the company into severe
cash-flow problems.
Taking risks Broadly speaking, it is wise to
The financial crisis of 2007–08 was restrict borrowings to around 25
largely caused by high leverage. to 35 percent of the total long-term When you combine
Individuals borrowed large amounts capital employed in the business. ignorance and leverage,
on credit cards and took out 100 Any higher than 50 percent is you get some pretty
percent mortgages, both against regarded as carrying too high a risk interesting results.
inadequate levels of income. When level for a normal business. After Warren Buffett
the debts could not be met and all, while the directors need to aim
US investor (1930–)
house prices fell, huge numbers for maximum profits, they are also
of people defaulted on their debts. responsible for the long-term health
The equally highly leveraged banks of the business, together with
stumbled; their problems were the welfare and security of staff,
made worse by the large-scale customers, and suppliers. ■