What Is Deleveraging?
Let me explain deleveraging directly: it's when a company or individual works to cut down their total financial leverage. Essentially, you're reducing debt, which is the flip side of leveraging up. The straightforward approach is to pay off existing debts and obligations right away from your balance sheet. If you can't manage that, you might face a higher risk of default.
Key Takeaways
- Deleveraging means cutting outstanding debt without taking on new debt.
- The aim is to lower the portion of your balance sheet that's funded by liabilities.
- If too many entities deleverage at once, it can trigger a financial recession and a credit crunch.
Understanding Deleveraging
You should know that leverage, or debt, comes with benefits like tax deductions on interest, delayed cash outflows, and avoiding dilution of equity. Debt is a core part of how businesses function today—they use it to finance operations, expansions, and R&D.
But if you load up on too much debt, the costs to service it, like interest payments, can damage your finances. That's when companies have to deleverage by selling assets or restructuring debt.
When used right, debt fuels long-term growth. It lets businesses cover expenses without issuing more equity, which would dilute shareholders' earnings. Issuing new stock reduces existing owners' percentage, and it can drop the stock price due to that dilution.
Issuing Debt
Instead of stock, companies can borrow. You might issue bonds to investors, who pay upfront and get interest plus principal back at maturity. Or you borrow from banks or creditors.
Take this example: if a company starts with $5 million in investor equity, that's their operating capital. If they borrow $20 million more, now they have $25 million for projects, boosting value for the same shareholders.
Deleveraging Debt
Companies often pile on debt for growth, but that amps up risk. If growth doesn't happen, the risk overwhelms them, and they have to deleverage by paying down debt. This can signal trouble to investors who want growth.
Your goal in deleveraging is to shrink the liability-funded part of the balance sheet. Do this by generating cash from operations to pay off debts, or sell assets like equipment, stocks, bonds, real estate, or business units, and use the proceeds to reduce debt. Either way, debt drops.
Here's a fast fact: the personal savings rate indicates deleveraging, as saving more means borrowing less.
When Deleveraging Goes Wrong
Wall Street might approve of successful deleveraging, like when layoffs boost share prices. But it doesn't always work out. If you have to sell unwanted assets at low prices to raise cash, your stock suffers short-term.
Worse, if investors think you're stuck with bad debt and can't deleverage, that debt's value tanks. You might sell at a loss or not at all, leading to failure. Firms holding such debt, like with Lehman Brothers in 2008, take big hits.
Economic Effects of Deleveraging
Borrowing drives economic growth and business expansion. But if everyone deleverages simultaneously by paying off debts and avoiding new ones, the economy hurts. During recessions, this limits credit and speeds up downturns.
Governments then step in with leverage—buying assets, guaranteeing securities, taking stakes in failing firms, offering tax rebates, or subsidizing purchases to stimulate spending.
The Federal Reserve can cut the federal funds rate to cheapen bank borrowing, lower interest rates, and encourage lending.
Another fast fact: taxpayers usually foot the bill for government debt from bailing out deleveraging businesses.
Examples of Deleveraging and Financial Ratios
Consider Company X with $2,000,000 in assets: $1,000,000 from debt, $1,000,000 from equity, earning $500,000 profit.
Key ratios include return on assets (ROA: net income over total assets, showing earnings from long-term assets), return on equity (ROE: net income over equity, showing profit from equity capital), and debt-to-equity (D/E: liabilities over equity, indicating financing balance).
For Company X: ROA = $500,000 / $2,000,000 = 25%; ROE = $500,000 / $1,000,000 = 50%; D/E = $1,000,000 / $1,000,000 = 100%.
Now, if they use $800,000 of assets to pay off $800,000 in liabilities, assets become $1,200,000 ($200,000 debt, $1,000,000 equity), still earning $500,000.
New ratios: ROA = $500,000 / $1,200,000 = 41.7%; ROE = $500,000 / $1,000,000 = 50%; D/E = $200,000 / $1,000,000 = 20%.
These show a healthier company, more appealing to investors and lenders.
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