Deleveraging is a process undertaken by a company to reduce the amount of total debt. It is an extreme measure carried out by an entity to pay off its obligations and existing debt on its balance sheet. If the company cannot deleverage in time, it may face the risk of defaulting on their payments or going into bankruptcy.
Deleveraging can be viewed from a microeconomic and macroeconomic level. A macroeconomic-level deleveraging, or deleveraging of an economy, is when multiple industries reduce their debt amount. It is measured as a reduction in total debt to a country’s GDP in the national account.
Debt is an important part of a company, as it can be used to fund its operations and investing activities. Using debt, a company can pay its bills and purchase assets without issuing shares and diluting shareholders’ earnings.
Apart from this, debt is raised to fund the initial growth of a company, but taking on large amounts of debt will increase the riskiness of the company. If the growth of the company does not go according to plan due to poor management or an economic downturn, the debt amount will be a burden on the company.
This is when a company will have to undertake deleveraging to reduce the impact of market volatility on the company’s balance sheet. A company can use the following techniques to deleverage:
A company can deleverage by selling assets, bonds, and a part of the business at a discount.
It can refinance existing debt in order to reduce monthly payments and interest rates.
It can deleverage by using excess cash from operational activities.
A public company can deleverage by issuing more share on the stock market.
Financial ratios, such as return on assets, debt-to-equity, and return on equity, can be used to understand the impact of deleveraging.
Return on Assets (ROA) = Net Income / Average Assets
Debt-to-Equity Ratio = Total Debt / Total Equity
Return on Equity (ROE) = Net Income / Total Equity
Example Deleveraging Calculation
Company A buys an asset worth $10 million using equity worth $3 million and debt worth $7 million. During the year, the net income is $600,000.
ROA: 600,000/10,000,000 = 6%
Debt-to-equity: 7,000,000/3,000,000 = 2.3x
ROE: 600,000/3,000,000 = 20%
Assume that at the end of the year, Company A decided to pay $5,000,000 of liabilities using $5,000,000 of assets. Now, the company holds $2,000,000 of debt and $5,000,000 of assets.
ROA: 600,000/5,000,000 = 12%
Debt-to-equity: 2,000,000/3,000,000 = 0.6x
ROE: 600,000/3,000,000 = 20%
Due to deleveraging in scenario 2, the company reports more attractive ratios; therefore, investors and lenders will prefer scenario 2 compared to scenario 1.
Advantages of Deleveraging
The company will get rid of toxic debt, a type of debt where the company cannot pay back the interest and principal amount.
A reduction in toxic debt will reduce the number of liabilities on the balance sheet and improve financial ratios, which will be looked at favorably by lenders and investors.
Disadvantages of Deleveraging
Deleveraging is a bad sign for the investors because it means a company is not able to achieve a level of growth required to pay off its debt. Hence, to reduce the amount of debt, a company may need to decrease the number of employees and undertake a fire sale of its assets. Such actions will result in a reduced share price for the company.
Impact of Deleveraging on the Economy
Deleveraging across multiple industries can slow economic growth, resulting in a sudden reduction in the availability of loans and increased constraints to obtain business loans.
It is because banks prefer lending to less risky companies, as the process of deleveraging occurs after a major financial crisis. It results in small and medium-sized companies being denied access to bank loans, which is followed by a collapse of the companies, as they will not be able to secure the cash to fund operational activities.
Furthermore, distressed firms must sell their assets to repay debt, causing the prices of assets to collapse. The pressure of deflation increases the burden of debt resulting in halting investments and decreasing the number of employees to reduce company-wide expenditure.
During the first few years of deleveraging, the consumption and GDP of an economy decline, which in turn creates a downward spiral. The government will need to step in to reduce the negative impact caused by the downturn.
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