Financial Leverage for E-commerce
Learn about the ins-and-outs of financial leverage for your online business.
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It’s estimated that 12-24 million ecommerce sites exist. With each day, new sites are added into the world. As with any type of business, having finances in order is key for growth and survival. Whether your financial leverage comes in a line of credit, loan, merchant cash advance or another form of funding, your ecommerce business will need it to make it.
Here, we will look at what financial leverage means in business, how it works, and your funding options for running an ecommerce business.
What is Financial Leverage?
When it comes to business, leverage can be defined as “using borrowed capital as a funding source” to expand assets. Since you’re borrowing money, or using debt, to finance assets with potential returns, it’s an investment strategy. The hope is that the benefits will eventually outweigh the costs. So, you’ll be able to pay back the debt, plus any interest, and gain profits.
As with any type of financing, there are both upsides and downsides. The benefits of using financial leverage like a line of credit, for example, include:
- Increasing available funds
- Boost credit
- Improve company growth
- Help promote potential acquisitions
- Grow profits
If your company is considered to be “highly leveraged,” then it means that most of the capital is in the form of debt. That comes with its own sets of risks, and we will get to that shortly.
How Financial Leverage Works
Financial leverage can be translated into a nominal amount by looking at a business’ financial statements. This will help you find out how much of the business is based in debt, or leveraged.
For starters, the main financial leverage formula to consider is:
Total Debt + Shareholder’s Equity = Financial Leverage Ratio
Shareholder’s equity can be calculated by taking the current number of outstanding shares multiplied by the current stock price. This will show you how much of your business is owed to others and not your own.
By looking at financial statements like a balance sheet, income statement or cash flow statement, you can also learn more about financial leverage with these formulas:
- Debt-to-assets ratio = total debt/total assets
- Debt-to-capital ratio = total debt / (total debt + total equity)
- Asset-to-equity ratio = total assets / total equity
- Debt-to-equity ratio = total debt / total assets
In these formulas, if you are running a retail ecommerce business and take out a line of credit, then that amount of credit becomes considered debt. It’s money you’re borrowing to buy assets, or equity. In this example, you may use this line of credit to purchase inventory, and inventory will translate to sales. Inventory is considered a current asset because it can be converted into cash within one year or less, if all goes well!
Risks of Financial Leverage
It’s easy to see from the above example that financial leverage is inherently taking on a risk. If you buy all that inventory on debt and cannot make sales, then you owe money and are not bringing in cash flow. That’s just one type of risk associated with financial leverage.
Financial leverage will also affect current and future cash flow. You’ll have to consider how much money you owe back on the borrowed principal amount as well as interest owed. Furthermore, your financial projections need to take into account financial leverage.
Depending on what you’re using the debt to purchase in forms of assets, there’s other risks like market risk, economic risk or the risk of natural disasters. If you use debt to purchase real estate and the values drop or a hurricane wipes out the building, then you’ve lost on your investment.
Know Your Options: Funding for Ecommerce
Whether you have brick-and-mortar location(s) or are solely running an online store, the explosion of ecommerce has ushered in the need for ecommerce funding. The good news is that since it’s such a popular business venture, there are many options to provide you with financial leverage.
- Bank loans: Bank loans are often one of the first places businesses look to for financing. However, when it comes to bank loans, there are many criteria your business will have to meet to be approved. This could make it somewhat challenging to get a small business loan from a bank if you’re a new business with little financial history, or if you have bad credit, to name a few hurdles. If that’s the case, then your next best bet is to focus on lines of credit.
- Business line of credit: If you have incremental business expenses, then a business line of credit could be what you need. A line of credit is a mix between a loan and a credit card which gives you a pre-approved amount of money that you can borrow. You’ll only pay interest on the amount you take. In most cases, a business line of credit will offer you with a bigger borrowing limit at a lower interest rate.
- Credit card: Like a personal credit card, a business credit card will lend you money and you’ll be expected to pay your credit card bill each month. In some instances, a business credit card can also serve like a loan where you may qualify for 0% intro APR (borrow without paying interest for a specified time period). As you use your credit card, you’re building your credit score, so it can be a win-win if you are starting up and able to pay your bills.
- SBA loan: An SBA loan is guaranteed by the U.S. Small Business Administration. These loans are a great resource for businesses that qualify. But, to qualify, you will have to be somewhat established as the approval is stringent. In this case, an intermediary lender provides your business with the funds, but the SBA backs a certain amount, so that your repayment terms could work out to be better than bank loans.
- Inventory financing: For ecommerce businesses undergoing unexpected growth, invoice (purchase order) financing means that a lender will be willing to pay your supplier or manufacturer for you. In return, you pay back the lender, plus interest. This helps ecommerce businesses get inventory or products to their customers sooner than they would otherwise be able to afford to do. It’s beneficial to attract and retain new customers as your business’ brand awareness takes off.
- Merchant cash advance: If you expect to receive a steady inflow of credit card transactions in your ecommerce business, a merchant cash advance can be one of the easiest methods for quick financing. You simply fill out an online application and can be approved practically immediately to receive funds. In return, a defined portion of your future credit card sales will be used to pay back the borrowed money.
- Venture capital: Say your ecommerce business is rapidly expanding and in need of hundreds of thousands or millions of dollars. Venture capital brings together investors that give you money upfront in exchange for equity in your business. Finding investors isn’t an easy path as you’ll have to prove the value of your business through a solid business plan and proof of concept.
Wrap Up: Financial Leverage and Ecommerce
Ecommerce businesses often rely on financial leverage because of the nature of the business. Whether you need a line of credit or quick cash to buy inventory, equipment, pay for warehousing or operational costs, etc., you will take on debt to grow.
Ecommerce is a quick-paced platform that requires you to provide value consistently to your customer. Since the internet moves so fast, you can set yourself apart by being prepared for whatever is to come. This will mean being able to get cash fast to meet spikes in demand and changing customer spending habits, so financial leverage is a concept you’ll want to know well.