Deleveraging: Definition, Overview & Formula
Debt financing is a necessary part of the business world.
When used correctly, the creation of debt can help a company achieve growth. This is without diluting its stock shares, asset prices, and shareholders’ earnings. However, when a company takes on too much debt things can get dangerous.
That’s where deleveraging comes into play. Economic difficulties such as a recession or a depression, or a market downturn can cause issues for businesses. In these difficult financial times, many companies will go through what is known as the deleveraging process. This is in order to avoid financial troubles and even potential bankruptcy.
But what exactly is deleveraging? And how can a company use it to reduce its debt? We’ll take a closer look at everything you need to know about the deleveraging process.
Table of Contents
- Deleveraging is the process by which a company or individual attempts to reduce their total financial leverage.
- Deleveraging is the opposite of leveraging.
- The most straightforward way that a company can deleverage is by paying off any debts and obligations that exist on its balance sheet.
- Deleveraging uses financial ratios such as return on assets, return on equity, and the debt-to-equity ratio.
What Is Deleveraging?
Deleveraging is the process of a company or individual attempting to decrease its total financial leverage. This is essentially the process of reducing debt, or the opposite of leveraging.
The most straightforward way for a company to deleverage is to pay off any debts or obligations. These are measures that exist on the debt portion of the balance sheet.
If a company is in a position where it cannot do this, then it could well be in a position where there is an increased risk of default.
Why Is Deleveraging Important?
Businesses commonly use debt to finance their business operations. They also use it to fund expansions and pay for things such as research and development. Because of this, companies are more likely to be forced to deleverage or pay down their debt. This is normally done by liquidating or selling their assets, or by restructuring their debt.
When done properly, debt is a fantastic tool that businesses can use to help fund their long-term growth. Debt can help businesses pay their obligations. This is without having to issue more equity, and prevent any further equity dilution of shareholders’ earnings.
Companies can also raise capital by issuing shares of stock. However, this means that the stock price for existing shareholders can drop due to oversaturation and share dilution. This is why debt is such a popular way to raise capital.
However, debt can be dangerous. Companies commonly take on lots of debt to initiate growth, but this comes with inherent risks. For example, if the growth doesn’t go as planned, then a company can be saddled with a large amount of debt and no income to pay it off. This is where companies will start to deleverage their debt.
The main goal of deleveraging is to reduce the percentage of a company’s balance sheet that is funded by its liabilities. This can be done in two different ways. By raising cash through normal business operations and using this capital to pay off debt. Or through liquidating assets such as equipment, bonds, stocks, or real estate and using these liquid assets to pay off debt.
What Is the Formula for Deleveraging?
Deleveraging makes use of financial ratios as its formula. The ratios used are:
- Return on assets:
This shows the efficiency of a company when it comes to earning money on its long-term assets. Long-term assets can include things such as equipment.
- Debt-to-equity ratio:
Debt-to-equity ratio shows how a company can finance the growth that it’s experiencing. As well as whether or not there are enough equity shares to cover its debt.
- Return on equity (ROE):
Return on equity shows how efficiently a company earns a profit. This is through using the capital that it has raised from issuing equity shares.
These financial ratios can be figured out using the following formulas:
Return on Assets Formula
Debt-to-Equity Ratio Formula
Return on Equity Formula
What Is an Example of Deleveraging?
Let’s say that Company X buys an asset that is worth $1 million. They purchase it using equity that is worth $300,000 and debt that is worth $700,000. During the financial year, their net income is $60,000.
With this information, we can use the formulas for the above financial ratios to figure out these important figures:
ROA = 60,000 / 1,000,000 = 6%
DtER = 700,000 / 300,000 = 2.3x
ROE = 60,000 / 300,000 = 20%
Now lets say that Company X decided to pay $500,000 of liabilities at the end of the year. They pay for this using $500,000 worth of assets. Now the company holds $200,000 of debt and $500,000 of assets.
ROA = 60,000 / 500,000 = 12%
DtER = 200,000 / 300,000 = 0.6x
ROE = 60,000 / 300,000 = 20%
By going through this period of deleveraging, Company X can report ratios that seem more attractive and a healthier proposition. Meaning that any potential investors and lenders will prefer the second set of results when compared to the first set of results.
What are the Advantages and Disadvantages of Deleveraging?
The advantages of deleveraging are that a company will be able to reduce its bad debts. This is debt that a company cannot pay back the interest and principal amount of. By reducing this debt, the number of liabilities on the balance sheet will decrease. This, therefore, improves their financial ratios. This makes the company look better to lenders and investors.
The disadvantages of deleveraging are the image that it portrays. A company that has to deleverage is showing that they are not able to achieve enough growth to pay off its debt. This means that the company has had to sell its assets or decrease staff numbers to pay off debt. Therefore resulting in a poor share price for the company.
Deleveraging is a key business tool. It is one of the many ways that a company can reduce its debt during bad times. If a company takes on large amounts of debt in the first place, it must either reduce its burden of debt substantially or be at risk of defaulting.
FAQs on Deleveraging
What Happens During Deleveraging?
When a company undergoes any level of deleveraging, it is attempting to decrease its total financial leverage. This is essentially doing anything they can to reduce their aggregate debt.
What 4 Things Can Be Done About Deleveraging?
In order to deleverage a company can:
- Cut overall business spending
- Sell or liquidate assets
- Raise capital through further growth
- Reduce its number of employees
Why Are Companies Deleveraging?
Companies will undergo deleveraging when their debt levels become too large to pay off through growth. This can often happen if a company takes on excessive debt to finance growth, but the growth doesn’t occur to the necessary level.
What Is an Over Leveraged Balance Sheet?
A balance sheet will become overleveraged when the levels of debt are too large. This will be in comparison to its operating cash flows and equity.
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