By: musicwhiz Leverage is a word often heard of these days, especially with the sub-prime credit crisis in full swing affecting everything from major US banks to far flung Japanese banks. Apparently, the amount of debt which investment banks take on is enough to cause a ripple effect and add to the major headaches experienced by reputable financial institutions, who have had to write down amounts of CDO and debt-related instruments to the tune of billions of USD. All these problems actually stemmed from debt, or leverage as it is known. There have been countless articles written on the ongoing sub-prime debacle, and George Soros has even written a book about it; so I will not delve further into this issue. Instead, let's examine the effects of leverage on companies and how it can make or break them. As readers may know, many companies (public and private) grow by taking on debt into their Balance Sheets. The reason for taking on debt is to use the money to grow the business and to earn a return on investment which is HIGHER than the interest rate charged on the debt. In effect, you are using money to build more money. Of course, one may argue that there are businesses out there which employ purely equity or cash flows from operations to grow organically and expand, but these "great" businesses are few and far between. Warren Buffett has personally identified the "great" business of See's Candy, which I will elaborate on in a subsequent post; but he admits that companies can also be "good" yet take on substantial leverage in order to grow the business. He is referring to companies which gear up to either grow the business through asset acquisitions, construction of new plants to increase production capacity, or to grow the business organically through vertical or horizontal integration. Read more...