Deleverage

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

[Important: To deleverage means to pay off debts while at the same time not incurring new debts.]

Leverage (or debt) has become an integral aspect of our society. At the most basic level, businesses use it to finance their operations, fund expansions and pay for research and development. By using debt, businesses can pay their bills without issuing more stock, thus preventing the dilution of shareholders' earnings.

For example, if 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. If the company further incorporates debt financing by borrowing $20 million, the company now has $25 million to invest in capital budgeting projects and more opportunity to increase value for the fixed number of shareholders.

Companies will often take on excessive amounts of debt to initiate growth. However, using leverage substantially increases the riskiness of the firm. If leverage does not further growth as planned, the risk can become too much for a company to bear. In these situations, all the firm can do is delever by paying off debt. Deleverage may 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's balance sheet that is funded by liabilities. Essentially, this can be accomplished in one of two ways. First, a company or individual can raise cash through business operations and use that excess cash to eliminate liabilities. Second, existing assets such as 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.

Wall Street can greet a successful deleveraging favorably. For instance, announcements of major layoffs can send share prices rising. However, deleveraging doesn't always go as planned. 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 if they can sell it at all. Inability to sell or service the debt can result in business failure. Firms that hold the toxic debt of failing companies can face a substantial blow to their balance sheets as the market for those fixed income collapses. Such was the case for firms holding the debt of Lehman Brothers prior to its 2008 collapse.

• To deleverage is to reduce outstanding debt and not incur new debts.
• The goal of deleveraging is to reduce the relative percentage of a business's balance sheet that is funded by liabilities.
• Too much systemic deleveraging can lead to financial recession and a credit crunch.

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. In this scenario, the company's return on assets, return on equity, and debt-to-equity values are as follows:

• Return on assets = $500,000 / $2,000,000 = 25%
• Return on equity = $500,000 / $1,000,000 = 50%
• Debt-to-equity = $1,000,000 / $1,000,000 = 100%

Instead of the above scenario, assume that at 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. If 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 follows:

• Return on assets = $500,000 / $1,200,000 = 41.7%
• Return on equity = $500,000 / $1,000,000 = 50%
• Debt-to-equity = $200,000 / $1,000,000 = 20%

The second set of ratios show the company to be much healthier, and investors or lenders would thus find the second scenario more favorable.

Borrowing and credit are integral pieces of economic growth and corporate expansion. When too many people and firms decide to pay off their debts all at once and not take on any more, the economy can suffer. When deleveraging creates a downward spiral in the economy, the government is forced to step in.

Governments take on debt (leverage) to buy assets and put a floor under prices or to encourage spending. This can come in a variety of forms, including buying mortgage-backed securities to prop up housing prices and encourage bank lending, issuing government-backed guarantees to prop up the value of certain securities, taking financial positions in failing companies, providing tax rebates directly to consumers, subsidizing the purchase of appliances or automobiles through tax credits, or a host of similar actions.

The Federal Reserve can also 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.

[Fast Fact: The personal savings rate is one indicator of deleveraging, as people save more money that they are not borrowing.]