Understanding and properly utilizing debt is not only a key to success in business, it is a key to success in life. Debt, also referred to as leverage, can be both a valuable tool and a recipe for disaster. Describe scenarios with both a proper use of debt and an inproper use of debt. Please be specific as well as realistic. Don’t describe a scenario that wouldn’t be possible in today’s environment (in other words, the days of no doc mortgages where you are given a loan without revealing your income or other personal information are over).
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“Leverage uses those items having a fixed cost that magnifies the return to a company. These fixed costs can either be related to company operations (operating leverage) or directly related to the costs of financing (financial leverage). Operating leverage deals with the fixed costs of assets, and are shown on the income statement as leases, depreciation, executive salaries, property taxes, and so on. Financial leverage deals with the fixed costs of financing, such as the amount of interest a company pays on debt.” (Adelman, 2014, p. 138) Assets such as delivery trucks, onsite equipment such as excavators, and personnel lifts can enable a company to produce more and in turn yield profit. If a company overextends itself attaining assets, and improperly(excessively) used credit to attain those assets then that is a swing in the wrong direction regarding the balance of debt and assets with leverage and could become too much of a liability for a company.
The purchase of a car has other benefits which are necessary and may not have a financial return and is not technically viable from a financial perspective. The purchase of a car would more reasonably not be expected to be a financial return since cars lose thousands of dollars in equity the moment, they’re driven off the lot and drop exponentially in value from there. The upside to that is that alternate benefits to the owner may yield financial returns via alternate routes such as the ability to drive to work. Some people do by cars from places like Florida to turn them around and sell them in the North East for a profit, but that is less common than the normal car purchase. However, that example turns a considerable amount of profit and does sound feasible.
An example of the use of proper debt leverage is having more equity than debt and meeting the lender’s requirements of being between 43-36% debt-equity-ratio and qualify for a home loan. Here are three highlights regarding the proper use of debt. “Good debt has the potential to increase your net worth or enhance your life in an important way. Bad debt involves borrowing money to purchase rapidly depreciating assets or only for the purpose of consumption. Determining whether a debt is good or bad sometimes depends on an individual’s financial situation, including how much they can afford to lose.” (Smith, 2021)
Adelman, P., Marks, A. (2014). Entrepreneurial Finance, 6th Ed. Pearson Education, Inc. New Jersey.
Smith, L. (2021). Good Debt vs. Bad Debt: What’s the Difference? Investopedia. Retrieved from https://www.investopedia.com/articles/pf/12/good-debt-bad-debt.asp