Deleverage

What is 'Deleverage'

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

BREAKING DOWN 'Deleverage'

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 the 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 one's balance sheet that is funded by liabilities. Essentially, this can be accomplished by 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.

Effect Of Deleveraging On Financial Ratios

As an example, 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:

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%

Next, 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:

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 generally, so investors or lenders would find the second scenario more favorable.