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 of an increased 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 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.

Effect Of Deleveraging On Financial Ratios

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:

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:

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

RELATED TERMS
  1. Leverage Ratio

    A leverage ratio is any one of several financial measurements ...
  2. Balance Sheet

    A balance sheet reports a company's assets, liabilities and shareholders' ...
  3. Capital Structure

    Capital structure is how a firm funds its operations and growth, ...
  4. Leverage

    Leverage results from using borrowed capital as a source of funding ...
  5. Debt Ratio

    The debt ratio is a financial ratio that measures the extent ...
  6. Asset Coverage Ratio

    The asset coverage ratio determines a company's ability to cover ...
Related Articles
  1. Investing

    Reading the Balance Sheet

    Learn about the components of the statement of financial position and how they relate to each other.
  2. Investing

    Debt Ratios

    Learn about the debt ratio, debt-equity ratio, capitalization ratio, interest coverage ratio and the cash flow to debt ratio.
  3. Investing

    Reinvesting Capital Gains In Leveraged Portfolios

    Don't get forced into action. Learn how to plan properly to avoid making rash decisions.
  4. Investing

    Useful Balance Sheet Metrics

    These metrics can help you better understand the information found on balance sheets.
  5. Insights

    What Happens to the Economy If China Deleverages

    Attempts to deleverage and institute reforms that will foster more sustainable growth could exacerbate an already slowing Chinese economy.
  6. Investing

    Equity Multiplier

    The equity multiplier is a straightforward ratio used to measure a company’s financial leverage. The ratio is calculated by dividing total assets by total equity.
RELATED FAQS
  1. How can an investor evaluate the leverage of an insurance company?

    Learn about insurance leverage, what leverage means in the context of insurance companies and what metrics investors should ... Read Answer >>
  2. If a company has a high debt to capital ratio, what else should I look at before ...

    Learn about some of the financial leverage and profitability ratios that investors can analyze to supplement examining the ... Read Answer >>
  3. What are the benefits and shortfalls of the Herfindahl-Hirschman Index?

    Learn about the differences between equity and debt financing and how they impact financials. Find out how businesses determine ... Read Answer >>
Trading Center