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Oct  2003

GUEST COLUMN

Financial leverage can be a friend or foe to the logger and sawmiller.

By Ron Forster

Leverage can give us the ability to do more with less. The bigger the lever, the more we can lift, push or accomplish with the same amount of effort. Financial leverage can work the same way—it can be an important tool in the management of a logging or sawmill business. There are lots of ways to calculate financial leverage, but it’s easy to visualize without getting caught up in ratios. Every asset a company owns—from logging equipment and land to accounts receivable and work in progress—is financed from only two sources: the owner’s cash, or someone else’s capital.

The more of those assets that are financed by somebody else, the higher the leverage for the business. This simple definition doesn’t account for the ability of a business to generate cash and repay its debt, so we often also consider leverage, or debt, in relation to cash flow. The cash flow measure, however, presents its own challenges in an industry like forestry where earnings can be quite volatile.

There are two primary benefits to increasing the leverage of a business. First, it provides a means to grow a business much faster than would otherwise be possible. Second, for any given level of profit, it generates a higher return on the equity invested in the company by its owners. It’s not hard to see how leverage can allow faster growth.

It’s no different than using a mortgage to assist an individual to buy a house before they have actually been able to save all the cash they would need to buy it without one. How leverage increases the rate of return on owner’s equity is just a little bit less obvious. Let’s assume we have a logging or sawmill business with assets of $10 million that generates a profit of $1 million a year. If we, the owners, have equity of $6 million, the return on our investment would be about 17 per cent. If we refinanced the company and borrowed another $3 million, reducing our equity to $3 million, that same $1 million profit (less interest on the additional $3 million we borrowed) would generate a return to us of about 27 per cent on our $3 million investment.

Why then are most bankers and many other financial professionals always talking about managing or reducing leverage? The answer is their desire to limit risk. Just like a big pry bar, financial leverage can be a dangerous tool. When things are levered and something unexpected happens, say a mill closure or a shutdown of logging operations due to fire, there are lots of ways to get hurt. There is a loss of control, lots of stress and often there is very little flexibility to fix the problem. Too much leverage at the wrong time is one of the primary reasons why many businesses fail to make it through down cycles.

It can also make it impossible to take advantage of new opportunities because there is just no more access to cash. Lenders are usually less willing to take on risk than owners because they don’t control the companies they lend to and they don’t participate in the bigger returns the owners get when their companies do well. This is a common source of frustration between borrowers and lenders that is not likely to go away. It helps, though, if we can understand that our angle on leverage is often different, for good reasons, on both parts. Most business people in the forest industry have a healthy respect for financial leverage. They know that as leverage increases, lenders usually want more reporting and controls on the borrower’s activities.

The overall cost of borrowing can go up and access to further funding, often just when it’s needed most, can be difficult. Financial flexibility is really the thing that is sacrificed by financial leverage. This is the flexibility that would allow a forestry–related company to ride through the tough times in this very cyclical industry, and to take advantage of opportunities for growth. Financial flexibility generally diminishes as leverage increases.

Like most things in life, we need the right balance of both. So what is the right amount of leverage? Well, there is really no such thing; even in the forest industry, every individual business has different priorities and plans that call for different leverage strategies. In industries with high capital needs and volatile cash flows, like today’s forest industry, leverage can be particularly dangerous. A businessman for whom I have a great deal of respect once told me something to the effect that “when the opportunity is right, don’t be afraid to borrow money and leverage assets. But repay it as fast as you can so you’ll be ready to do it again when the next deal comes along.”

Overall, that’s not a bad strategy because it keeps the notion clear that leverage helps grow a business, but we have a lot more flexibility when it’s low. The important thing is to have a plan for the future of your business, and how you’re going to finance it. The message is not that debt is a bad or good thing—it simply needs to be considered carefully as part of the overall strategic and operational planning for a business. That’s especially true for an industry like forestry that has its ups and, right now, its downs. There are lots of ways to structure the funding of your business and it’s important to work with good financial professionals, including bankers, to plan for your company’s financial future.

Ron Forster is a senior account manager, specializing in the forest industry, with RBC Royal Bank.

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