Leverage is a financial strategy that allows businesses to amplify operations by borrowing funds or using financial instruments to increase investments. It offers the potential for higher returns, expanded operations, and growth beyond available capital.
Leverage, when used strategically, empowers businesses to achieve greater success, expand their market presence, and ultimately thrive in a competitive landscape. Leverage plays a very important role in business. Companies use it to make the most of their resources, increase operational capacity, or seize growth opportunities.
In this article, we will look at how businesses can generate leverage using letters of credit (LCs) and use it to increase the returns on their investments.
Understanding Leverage
Debt is the primary source of leverage. By introducing debt into a business’s capital structure, they are able to access additional funds that can be used to invest in growth opportunities.
Businesses have two sources of capital: debt, which involves borrowing funds with repayment obligations, and equity, which represents ownership in the company and offers potential returns through dividends and capital appreciation.
The leverage ratio measures how leveraged a company is. It compares the amount of debt incurred by the company to other balance sheet accounts such as the equity capital invested in by the business owners, the total capital available to the firm, or the company’s assets. By calculating the leverage ratio, businesses can evaluate their capital structure, assess their risk profile, and make informed decisions regarding their financing strategies.
For example, let’s consider a company with 100 million Naira invested by its shareholders that gets a 50 million Naira loan from a bank or raises that amount by issuing a bond in the capital market. The leverage ratio can be calculated by dividing the total debt by the total equity, or total capital.
Leverage Ratio = Total Debt / Total Equity
Leverage Ratio = 50,000,000 / 100,000,000 Naira
Leverage Ratio = 0.5
Leverage Ratio = Total Debt / Total Capital
In this case, the leverage ratio would be:
Leverage Ratio = 50,000,000 / 150,000,000 Naira
Leverage Ratio = 0.33
The leverage ratio can be visualized as a gradient scale ranging from 0 to 1. When the leverage ratio is closer to 0, it indicates a lower level of leverage, meaning the company relies more on equity than debt to finance its operations. As the leverage ratio moves towards 1, it signifies a higher level of leverage, indicating that the company has a more significant proportion of debt compared to equity. A leverage ratio closer to 0 means the company has a stronger equity position, while a ratio closer to 1 indicates a higher reliance on debt financing.
Leverage offers the key advantage of amplifying investment returns. By borrowing funds at a lower cost than the anticipated return on investment, businesses can capitalize on the difference and increase their profitability. Effective use of debt allows businesses to optimize resource utilization and potentially attain higher returns on invested capital.
Does debt have an impact?
Debt inclusion in a company’s capital structure is a contentious issue in corporate finance. According to the Modigliani-Miller theorem, in a perfect market, a firm’s capital structure has no effect on its overall market value or the average cost of capital. Instead, the cash flow of a company determines its value. In practice, however, debt introduces risks such as interest rate mismatches with expected returns and currency risk if priced in a foreign currency, which could threaten cash flow. When properly managed, debt can be advantageous if the return on investment exceeds the cost of capital. Overall, the impact of debt on a company’s value is determined by real-world factors other than the theorem’s idealized assumptions.
Letters of Credit
Letters of credit (LC) are trade instruments that guarantee payment from a bank on behalf of its customer. They play an important role in international trade by facilitating secure transactions between buyers and sellers and are used to reduce risk when trading within and across national borders. The issuing bank issues an LC to the supplier’s bank as a binding commitment, guaranteeing payment to the seller upon fulfillment of predetermined conditions.
Letters of credit are shared as a SWIFT (Society for Worldwide Interbank Financial Telecommunication) message from the buyer’s bank and are confirmed by the seller’s bank. They are the safest and most secure way to do business, as they protect both the buyer and seller.
For sellers, an LC guarantees they will receive payment for the goods or services they provide, provided they meet the conditions outlined in the LC. This assurance significantly increases the level of trust in the transaction, especially when dealing with new or unfamiliar buyers. With the backing of a reputable bank, the seller can confidently proceed with the transaction, knowing that they will get paid on time.
On the buyer’s side, the LC provides protection against potential risks, such as non-performance or fraudulent activity by the seller. The buyer can specify the required conditions and quality standards in the LC, ensuring that they only pay for the goods or services if they meet the agreed-upon specifications. This protection minimizes the buyer’s exposure to financial loss and ensures they receive what they ordered before paying.
Letters of credit can be a source of leverage for traders. For example, a manufacturing company can use a letter of credit to finance the production and export of goods to international markets. An LC from a top-rated bank demonstrates high credit quality and a commitment to meeting financial obligations by providing payment assurance upon meeting specified conditions. This builds trust in the seller, allowing the buyer to negotiate better terms and payment structures. Furthermore, discount houses may be willing to discount standby letters of credit and bank guarantees in some cases, increasing their financial flexibility.
Advantages of Letters of Credit
- Increased credit capacity: Obtaining an LC establishes a credit line for a business with a bank. The LC acts as a payment guarantee to the seller, enabling the buyer to acquire goods or services without impacting their capital or existing credit capacity.
- Improved liquidity management: By utilizing an LC for deferred payment instead of tying up cash or credit lines, buyers can improve cash flow and optimize working capital. Having liquidity available outside of the balance sheet provides businesses with greater flexibility in managing their financial resources.
- Risk mitigation: The involvement of a bank in issuing the LC adds an extra layer of security, reducing payment risks for both the buyer and seller. By leveraging an LC, businesses can safeguard themselves against potential losses resulting from counterparty non-performance or default.
- Trade facilitation: LCs are instrumental in facilitating international trade. With banks as intermediaries, LCs foster trust and reduce uncertainties, enabling businesses to access global markets and attract reputable trade partners. The off-balance-sheet nature of LCs provides financial flexibility while ensuring security through bank guarantees. In summary, LCs streamline trade processes, expand market opportunities, and offer reliable financial support for trade facilitation.
Off-balance sheet financing
The true value of leveraging letters of credit (LCs) is the ability to access off-balance-sheet financing, allowing businesses to expand capacity with minimal capital investment. Off-balance-sheet financing allows companies to finance their assets without increasing the liabilities on their balance sheet. This strategy aims to reduce debt-equity and leverage ratios, which can improve the company’s financial position and risk profile. Companies can effectively tap into external resources using LCs without significantly burdening their balance sheets, resulting in increased financial flexibility and reducing the risks associated with high debt levels.
Let’s examine a practical example of how letters of credit (LCs) can be leveraged to increase financial capacity. Imagine an oil trader who regularly supplies $1,000,000 worth of jet fuel to an airline every quarter. Now, this trader comes across an exciting opportunity to expand their business by supplying multiple airlines, which could potentially increase their capacity tenfold. However, there is a stumbling block: the trader does not have immediate access to the $10,000,000 capital required to seize this opportunity. For simplicity, we’ll assume a net margin of 20% and disregard any economies or diseconomies of scale that may arise from increased capacity.
Trading without leverage
- The trader enters into an agreement to purchase $1,000,000 worth of jet fuel from the refinery.
- The trader executes his purchase order from the airline and transfers ownership of the jet fuel to the airline.
- The airline pays the trader $1,200,000 for the jet fuel after 90 days, completing his sales cycle.
- The trader pays the refinery $1,000,000 from proceeds of sales and has a net gain of $200,000
Trading with leverage
- The trader contacts Breeze to arrange for an LC that will allow him to put off payments for up to 90 days. The trader pays Breeze $750,000 as an issuing fee, which is 7.5% of the cargo’s value ($10,000,000).
- Breeze sends the LC to the refinery’s bank as a SWIFT message from the issuing bank, assuring the refinery of payment after 90 days on behalf of the trader.
- The refinery transfers ownership of the cargo to the trader.
- The trader supplies the airlines as part of the execution of its purchase order
- The airlines pay the trader $12,000,000 for the jet fuel shipment on the agreed-upon date.
- The trader pays the refinery $10,000,000 for the goods sold 90 days after receiving the shipment, resulting in a net gain of $1,250,000.
Let’s look at these two scenarios that demonstrate how a letter of credit can give a business greater leverage to enhance its operational capacity.
In the first scenario, the trader invests $1,000,000 and achieves a net gain of $200,000. And, in the second scenario, the trader is able to get a $10,000,000 credit line using a letter of credit. The trade pays an issuing charge of $750,000, equal to 7.5% of the value of the letter of credit. By increasing their investment, the business is able to enjoy a net gain of $1,250,000. If we assume an initial cash position of $1,000,000 for both scenarios, then we can conclude that the second scenario allows the business to 7.5x its returns without any additional capital.
Businesses can effectively leverage LCs to unlock financial flexibility, strengthen their competitive position, and drive success in today’s volatile business landscape with careful management and an understanding of the associated risks.
Breeze provides uncollateralized letters of credit (LCs) to African businesses for expanding international trade. Our LCs, issued by top financial institutions, offer a powerful solution for increasing operational capacity, maximizing investment returns, and building unwavering trust with global business partners.
Visit https://www.breeze.africa/letter-of-credit to get started.
