What is deleveraging?

Deleveraging is when a firm or individual aims to decrease its total financial leverage. The simplest way for achieving deleverage is to pay off any existing debt on its balance sheet. When this is not possible, the company or individual may be in a position that increases its risk of default.

Any company that wants to initiate growth will contract excessive amounts of debt. Nevertheless, using leverage substantially increases the riskiness of the firm. If leverage does not grow as planned, the risk can become too high for the firm to bear. To correct this debt excess, the firm can deleverage by paying off debt. For investors who require a certain amount of growth, deleverage might be seen as a bad indicator.

The aim of deleveraging is to decrease the relative amount of the balance sheet that is funded by liabilities. This debt reduction can be accomplished in two ways:

  • When a firm or individual can raise cash through business operations and use that excess cash to eliminate liabilities.
  • When assets like equipment, stocks, bonds, real estate or business arms, among others, can be sold to acquire liquidity and thus the extra cash used to pay off debt.

How deleveraging works

Say that a company has £10,000,000 in assets, of which £5,000,000 is funded by debt and £5,000,000 is funded by equity. During the business year, the firm earns £1,000,000 in net income. Let’s see the relative return ratios:

Return on assets = £1,000,000 / £10,000,000 = 10%

Return on equity = £1,000,000 / £5,000,000 = 20%

Debt-to-equity = £5,000,000 / £5,000,000 = 100%

If instead of the above scenario we assume that at the beginning of the year the company decided to use £2,000,000 of assets to pay off £2,000,000 of debt, the company would have £8,000,000 in assets, of which £3,000,000 is funded by debt and £5,000,000 is funded by equity. If the company made the same £1,000,000 during the year, its return on assets, return on equity, and debt-to-equity values would be:

Return on assets = £1,000,000 / £8,000,000 = 12.5%

Return on equity = £1,000,000 / £5,000,000 = 20%

Debt-to-equity = £3,000,000 / £5,000,000 = 60%

Here, the ratios look way healthier, hence potentially attracting more investors or lenders.

Category: Financial Glossary

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