Deleveraging is when a company or individual takes measures to decrease its total financial leverage. In other words, deleveraging involves reducing debt, acting as the opposite of leveraging. The most straightforward approach to deleveraging is to pay off any existing debts and obligations on the balance sheet. If this can’t be accomplished, the company or individual might face an increased risk of default.
Key Takeaways
- To deleverage is to reduce outstanding debt without incurring any new debt.
- The aim of deleveraging is to reduce the percentage of liabilities on a company’s balance sheet.
- Extensive systemic deleveraging can precipitate financial recessions and credit crunches.
Embracing the Concept of Deleveraging
Leverage, essentially debt, has its advantages, such as tax benefits on deducted interest, deferred cash outlays, and avoiding equity dilution. Debt has become a pivotal part of modern economies—businesses use it to finance operations, fund expansions, and support research and development (R&D).
However, excessive debt can burden companies with significant interest payments, consequently harming their financial well-being. As a result, companies may need to deleverage by paying down debt, often achieved through liquidating assets or restructuring debt.
If managed properly, debt can be a catalyst for long-term growth. Leveraging allows businesses to meet their financial needs without diluting their shareholding through equity issuance.
Issuing Debt: The Double-Edged Sword
An alternative for companies to raise funds is by issuing debt to investors in the form of bonds. Investors pay the principal amount upfront, then receive periodic interest payments, alongside the principal, at the bond’s maturity date. Companies might also borrow money from banks or creditors.
An Example to Consider
Imagine a company established with an investment of $5 million. Adding debt financing by borrowing $20 million gives the company $25 million to invest in capital projects, creating more avenues to increase value for its investors.
Deleveraging Debt
Although leveraging can promote growth, excessive leverage elevates risk. If growth does not materialize as anticipated, deleveraging becomes necessary to reduce this risk. However, this move can be a red flag to investors expecting growth.
Deleveraging aims to reduce the proportion of a business’s balance sheet funded by liabilities. This can be achieved by either increasing cash flow from operations to pay off liabilities or selling assets to decrease debt.
When Deleveraging Goes Wrong
Successful deleveraging can lead to positive market reactions. However, it doesn’t always work as planned. Companies might sometimes sell assets at undesirable fire-sale prices to raise capital for debt reduction, often negatively impacting share prices. If investors sense a company’s struggle with bad debt, the company’s financial health may further deteriorate.
Economic Effects of Deleveraging
Borrowing and credit are crucial for economic growth. Overzealous deleveraging, particularly during economic downturns, can hamper credit growth, causing further economic deceleration.
In such scenarios, governments may intervene, using fiscal stimulus or monetary policies to stabilize the economy. For instance, the Federal Reserve might lower interest rates to make borrowing cheaper, encouraging lending and spending.
Practical Examples and Financial Ratios of Deleveraging
Let’s consider the example of Company X, possessing $2,000,000 in assets funded equally by debt and equity, and earning $500,000 in net income. Here are the key financial metrics:
- ROA: 25%
- ROE: 50%
- Debt-to-equity: 100%
If Company X uses $800,000 from its assets to pay down an equivalent amount of debt:
- ROA: 41.7%
- ROE: 50%
- Debt-to-equity: 20%
Such improvements in financial ratios underscore healthier company scenarios, making them more attractive to investors and lenders alike.
Related Terms: financial leverage, balance sheet, risk of default, equity, bonds, liquidity, recession.
References
- Federal Reserve Bank of St. Louis. “Personal Saving Rate”.
- Federal Reserve Bank of St. Louis. “Effective Federal Funds Rate”.
