Deleverage

What Is Deleveraging?

Deleveraging is when a company or individual attempts to decrease its total financial leverage. In other words, deleveraging is the reduction of debt and the opposite of leveraging. The most direct way for an entity to deleverage is to immediately pay off any existing debts and obligations on its balance sheet. In the event that unable to do this, the company or individual might be in a position of an increased risk of default.

Understanding Deleverage

Leverage (or debt) enjoys benefits, for example, tax benefits on the interest deducted, deferred cash outlays, and avoiding equity dilution. Debt has become an integral aspect of our society — at the most essential level, businesses use it to finance their operations, fund expansions, and pay for research and development.

However, assuming companies take on too much debt, the interest payments or cost to service that debt can do financial damage to the company. As a result, companies are sometimes forced to deleverage or pay down debt by liquidating or selling their assets or restructuring their debt.

Whenever used properly, debt can be a catalyst to help a company fund its long-term growth. By utilizing debt, businesses can pay their bills without giving more equity, in this manner preventing the dilution of shareholders' earnings. Share dilution happens when companies issue stock, which leads to a reduction in the percentage of ownership of existing shareholders or investors. Despite the fact that companies can raise capital or funds by giving shares of stock, the drawback is that it can lead to a lower stock price for existing shareholders due to share dilution.

Giving Debt

The alternative is for companies to borrow money. A company could issue debt directly to investors as bonds. The investors would pay the company a principal amount upfront for the bond and in return, get paid periodic interest payments as well as the principal back at the bond's maturity date. Companies could likewise raise money by borrowing from a bank or creditor.

For example, in the event that a company formed with an investment of $5 million from investors, the equity in the company is $5 million — the money the company uses to operate. Assuming the company further incorporates debt financing by borrowing $20 million, the company presently has $25 million to invest in capital budgeting projects and more opportunity to increase value for the fixed number of shareholders.

Deleveraging Debt

Companies will often take on excessive amounts of debt to initiate growth. However, utilizing leverage substantially increases the riskiness of the firm. In the event that leverage does not further growth as expected, the risk can become too much for a company to bear. In these circumstances, all the firm can do is delever by paying off debt. Deleverage might be a red flag to investors who require growth in their companies.

The goal of deleveraging is to reduce the relative percentage of a business' balance sheet that is funded by liabilities. Essentially, this can be accomplished in one of two ways. Initial, a company or individual can raise cash through business operations and use that excess cash to eliminate liabilities. Second, existing assets, for example, equipment, stocks, bonds, real estate, business arms, to name a few, can be sold, and the resulting proceeds can be directed to paying off debt. In either case, the debt portion of the balance sheet will be reduced.

The personal savings rate is one indicator of deleveraging, as people save more money, they are not borrowing.

When Deleveraging Goes Wrong

Wall Street can greet a successful deleveraging well. For instance, announcements of major cutbacks can send share prices rising. However, deleveraging doesn't go as planned 100% of the time. When the need to raise capital to reduce debt levels forces firms to sell off assets that they don't wish to sell at fire-sale prices, the price of a company's shares generally suffers in the short run.

Worse yet, when investors get the feeling that a company is holding bad debts and unable to deleverage, the value of that debt plummets even further. Companies are then forced to sell it at a loss in the event that they can sell it by any stretch of the imagination. Powerlessness to sell or service the debt can result in business failure. Firms that hold the toxic debt of bombing companies can face a substantial blow to their balance sheets as the market for those fixed income instruments collapses. Such was the case for firms holding the debt of Lehman Brothers prior to its 2008 collapse.

Economic Effects of Deleveraging

Borrowing and credit are integral pieces of economic growth and corporate expansion. When too many people and firms decide to pay off their debts at the same time and not take on any more, the economy can suffer. In spite of the fact that deleveraging is regularly good for companies, assuming it happens during a recession or an economic downturn, it can limit credit growth in an economy. As companies deleverage and cut their borrowing, the downward spiral in the economy can accelerate.

As a result, the government is forced to step in and take on debt (leverage) to buy assets and put a floor under prices or to encourage spending. This fiscal stimulus can come in a variety of forms, including buying mortgage-backed securities to prop up housing prices and encourage bank lending, giving government-backed guarantees to prop up the value of certain securities, taking financial positions in bombing companies, providing tax rebates directly to consumers, subsidizing the purchase of appliances or automobiles through tax credits, or a large group of comparable activities.

The Federal Reserve can likewise lower the federal funds rate to make it less expensive for banks to borrow money from each other, push down interest rates and encourage the banks to lend to consumers and businesses.

Taxpayers are typically responsible for paying off federal debt when governments bail out businesses that have suffered and are going through the deleveraging process.

Examples of Deleveraging and Financial Ratios

For example, let's assume Company X has $2,000,000 in assets, of which, $1,000,000 is funded by debt and $1,000,000 is funded by equity. During the year, Company X earns $500,000 in net income or profit.

Despite the fact that there are numerous financial ratios available to measure a company's financial health, three of the key ratios that we'll be utilizing are outlined below.

• Return on assets (ROA) is the total assets divided by net income, which shows how well a company earns money on its long-term assets like equipment.
• Return on equity (ROE) is calculated by dividing net income by shareholders' equity, which shows how well a company earns a profit by utilizing the capital it raised from giving equity shares.
• Debt-to-equity (D/E) is calculated by dividing a company's liabilities by shareholders' equity. Debt-to-equity shows how a company is financing its growth and whether there are sufficient equity shares to cover its debt.

Below are the ratio computations utilizing the financial information from Company X.

• Return on assets = $500,000/$2,000,000 = 25%
• Return on equity = $500,000/$1,000,000 = half
• Debt-to-equity = $1,000,000/$1,000,000 = 100 percent

Instead of the above scenario, assume that toward the beginning of the year the company decided to use $800,000 of assets to pay off $800,000 of liabilities. In this scenario, Company X would now have $1,200,000 in assets, of which $200,000 is funded by debt and $1,000,000 is funded by equity. On the off chance that the company made the same $500,000 during the course of the year, its return on assets, return on equity, and debt-to-equity values would be as per the following:

• Return on assets = $500,000/$1,200,000 = 41.7%
• Return on equity = $500,000/$1,000,000 = half
• Debt-to-equity = $200,000/$1,000,000 = 20%

The second set of ratios demonstrate the company to be a lot healthier, and investors or lenders would consequently find the second scenario more favorable.

Features

• To deleverage is to reduce outstanding debt without bringing about any new debt.
• The goal of deleveraging is to reduce the relative percentage of a business' balance sheet funded by liabilities.
• Too much systemic deleveraging can lead to financial recession and a credit crunch.