DELEVERAGING: Effects in Businesses and the Economy

deleveraging

During times of economic distress, such as a recession or depression, many businesses, limited partnerships, and individual families deleverage their balance sheets. You may not grasp what deleveraging implies or why it is so crucial unless you have a background in economics or finance. Let’s the the economic impacts of deleveraging on businesses and the economy.

What Is Deleveraging?

Deleveraging is essentially debt reduction. More specifically, it involves lowering the relative percentage or absolute dollar amount of a debt-financed balance sheet. It can be performed by either increasing cash flow or selling assets such as real estate, stocks, bonds, divisions, subsidiaries, and so on. When deleveraging is done voluntarily, the goal is most commonly to reduce risk. When done as a result of a change in financial circumstances, it is also utilized to prevent bankruptcy.

Understanding Deleveraging

Leverage (or debt) has benefits such as tax benefits on deducted interest, postponed cash outlays, and avoiding stock dilution. Debt has become a fundamental part of our society; at its most basic, corporations utilize it to finance operations, support expansions, and pay for R&D.

However, if a corporation incurs too much debt, the interest payments or companies associated with servicing that debt might cause financial harm to the company. As a result, companies are occasionally required to deleverage or pay down debt by liquidating or selling assets or restructuring debt.

Debt, when used correctly, can be a driver for a company’s long-term success. Businesses can pay their debts using debt rather than issuing more equity, preventing dilution of shareholder earnings. Share dilution happens when a company issues stock, reducing the percentage of ownership held by existing shareholders or investors. Although companies can obtain capital or funds by issuing shares of stock, the negative is that share dilution might result in a reduced stock price for existing shareholders.

Creating Debt

Companies can borrow money as an alternative. A firm could issue debt to investors directly in the form of bonds. The investors would pay the corporation a principal amount up front for the bond and get periodic interest payments as well as the principal back when the bond matured. Companies could also raise funds by borrowing from a bank or creditor.

For example, if a firm is created with a $5 million investment from investors, the company’s equity is $5 million—the money the company uses to run. If the corporation borrows another $20 million in debt financing, it now has $25 million to invest in capital budgeting projects and more potential to increase value for the fixed number of shareholders.

Debt Deleveraging

Companies will frequently incur exorbitant levels of debt in order to commence expansion. However, using leverage significantly raises the firm’s risk. If leverage does not increase as expected, the risk may become too great for a corporation to bear. In these cases, the firm’s only option is to delever through paying down debt. Deleverage may be a red flag for investors looking for growth in their companies.

Deleveraging is to minimize the proportion of a company’s balance sheet that is funded by liabilities. This can essentially be performed in one of two ways. First, a corporation or individual can generate cash through commercial operations and use the excess revenue to pay off debts. Second, existing assets such as equipment, stocks, bonds, real estate, and business arms, to name a few, can be sold, with the proceeds going toward debt repayment. In either situation, the balance sheet’s debt portion will be lowered.

Formula

To understand the impact of deleveraging, financial measures like as return on assets, debt-to-equity, and return on equity can be employed.

Net Income / Average Assets = Return on Assets (ROA).

Total Debt / Total Equity = Debt-to-Equity Ratio

Net Income / Total Equity Equals Return on Equity (ROE).

Examples of Financial Ratios and Deleveraging

Assume Company X has $2,000,000 in assets, of which $1,000,000 is financed by debt and $1,000,000 is financed by equity. Company X earns $500,000 in net income or profit during the course of the year.

Although there are other financial ratios available to assess a company’s financial health, we’ll focus on three crucial ratios.

#1. Return on Assets (ROA)

Return on assets (ROA) is calculated by dividing total assets by net income, and it demonstrates how well a company generates money on long-term investments such as equipment.

#2. Return on Equity (ROE)

Return on equity (ROE) is computed by dividing net income by shareholders’ equity. It illustrates how well a company produces a profit by issuing equity shares.

#3. Debt-to-equity Ratio (D/E)

The debt-to-equity ratio (D/E) of a corporation is derived by dividing its liabilities by its shareholders’ equity. Debt-to-equity ratio demonstrates how a company finances its growth and whether there are enough equity shares to service its debt.

The ratio calculations based on Company X’s financial data are shown below.

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

Instead of the aforementioned situation, suppose the corporation decided at the start of the year to use $800,000 in assets to pay off $800,000 in liabilities. In this situation, Company X now has $1,200,000 in assets, $200,000 of which is backed by debt and $1,000,000 by stock. If the company earned the same $500,000 during the year, its return on assets, return on equity, and debt-to-equity ratios would be as follows:

Asset return = $500,000 / $1,200,000 = 41.7 percent

Return on investment = $500,000 / $1,000,000 = 50%

Debt-to-equity ratio = $200,000 / $1,000,000 = 20%

The second set of numbers shows the company to be considerably healthier, and hence investors or lenders would prefer the second situation.

What is it about leverage that makes it both effective and destructive?

This mathematical relationship is what makes leverage so successful on the positive side while being so devastating on the negative. When a corporation or individual delevers, it reduces the danger of total financial ruin if things go wrong. However, it reduces the upside of what they might make when things are going well. Although it may imply foregoing some potential rewards, deleveraging removes a lot of risk from the equation. Thus it allows you to focus on improving the core business or regaining your financial breath.

BP p.l.c., the British oil and natural gas behemoth, was a well-known example of deleveraging in the last decade. Following the 2010 Gulf of Mexico oil spill, the company liquidated assets to raise $10 billion, decreasing its holdings and bolstering its cash reserves. 1 These initiatives enabled it to continue operating while paying tens of billions of dollars in fines and penalties.

Deleveraging and Toxic Debt

Inability to sell or service debt can lead to the failure of a business. Firms holding toxic debt from failing companies may suffer a significant hit to their balance sheets if the market for those fixed-income instruments collapses. This was the case for firms that held Lehman Brothers’ debt before its 2008 bankruptcy.

Banks must hold a certain amount of their assets in reserve to help satisfy their obligations to creditors. This includes depositors who may request withdrawals. They are also required to maintain specified capital-to-debt ratios. Banks deleverage to preserve these ratios when they are concerned that the loans they issued will not be repaid or when the value of the assets they own falls. Lending slows when banks are apprehensive about being repaid. When lending slows, customers are unable to borrow, limiting their ability to purchase goods and services from businesses. Similarly, because businesses can’t borrow to expand, hiring slows, and some are compelled to sell assets at a loss to repay bank loans.

When a large number of banks deleverage at the same time, stock values fall as companies that can no longer borrow from banks are revalued based on the price of assets they are attempting to sell at a discount. Debt markets may crash as investors become hesitant to hold bonds issued by struggling companies or to purchase ventures in which debt is packaged.

The Benefits of Deleveraging

The company will pay off toxic debt, which is debt for which the corporation cannot repay the interest and principle.

Reduced toxic debt reduces the quantity of obligations on the balance sheet. Hence, it improves financial ratios, which lenders and investors will value.

The Drawbacks of Deleveraging

Deleveraging is a negative indicator for investors since it indicates that a firm is unable to attain the level of growth required to pay off its debt. As a result, in order to minimize the amount of debt, a corporation may need to cut the number of employees and conduct a fire sale of its assets. Such measures will result in a decrease in the company’s share price.

The Effects of Deleveraging on the Economy

Deleveraging across many industries can stifle economic growth by reducing the availability of loans and increasing the difficulty of obtaining business loans.

Because banks prefer financing to less risky companies following a big financial crisis, the process of deleveraging happens. It results in small and medium-sized companies being denied access to bank loans. This leads to the companies failing because they lack the funds to fund operational activities.

Furthermore, distressed corporations must sell assets to repay debt, leading asset prices to plummet. Deflationary pressures raise the weight of debt, leading to a halt in investments and a reduction in the number of staff in order to decrease company-wide expenditure.

During the first few years of deleveraging, an economy’s consumption and GDP fall, creating a vicious spiral. To mitigate the bad effects of the downturn, the government will need to step in.

In conclusion

When the private sector is deleveraging, the government cannot continue to take up leverage indefinitely since taxpayers must eventually repay government debt. The problem quickly becomes convoluted, and there are no straightforward solutions. In order to break the negative spiral, effective economic policies must be implemented.

Deleveraging FAQs

What is deleveraging of a business?

On a microeconomic level, deleveraging is the process through which a corporation reduces its total debt. It is a drastic move used by a company to pay off its commitments and existing debt on its balance sheet.

What is deleveraging balance sheet?

Balance-sheet deleveraging is the inverse of balance-sheet leveraging. When you leverage your balance sheet, you add to the balance sheet debt. Deleveraging occurs when you reduce the debt on your balance sheet by repaying some of your loans.

What do you mean by financially leveraged?

Financial leverage is the use of debt to acquire additional assets. Leverage is used to boost the return on equity. Excessive financial leverage, on the other hand, raises the risk of failure by making debt repayment more onerous.

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