The primary issue with leverage has to do not with how efficiently you use assets but with how efficiently you use your net worth, or equity, to multiply—or leverage—your investment. In other words, the profit your business returns on equity or net worth should be higher than its return on assets in proportion to your use of borrowed money to fund your business.

Too much leverage, though, puts both your organization and its creditors at risk. Too many liabilities can put your back to the wall quickly if a few things start to go against you. Bankers may call in their loans, suppliers won’t ship product, and good employees may look elsewhere. The employee risk is even greater if the company is not seen as able to meet its payroll consistently, or if it is not perceived as staying competitive technologically. Your highly mobile knowledge workers want to be at least on the cutting edge, if not the bleeding edge, of their fields. If your firm can’t offer that opportunity technologically, you may well lose the best, the brightest and the highest-initiative people on your staff. Too much leverage exposes you to the risk of not having enough of a financial shock-absorber to get over the potholes that every business encounters. In the other direction, too little leverage can force return on equity below industry norms to the point of making you less competitive.

The cash-flow implications here are simple. The greater the leverage, the greater the risk that other people’s fears and decisions can pull the plug. The lower the leverage, the lower the return available to owners of the business. The right leverage point or range is largely defined by market forces. Those forces include investor and creditor expectations that interact around a variety of perceived trade-offs between risk and reward.

Taken From : Cash Rules