Definition
Deleveraging is a financial term referring to the reduction of debt in a company’s financial structure. It is typically achieved by paying off existing debts, converting debt to equity, or generating operational profits. Deleveraging aims to lower the financial risk associated with high debt levels.
Key Takeaways
- Deleveraging is a process in which a company or individual attempts to decrease its total financial leverage, essentially working towards reducing the amount of debt they have in their financial structure.
- Deleveraging can help to create a more stable financial position through the repayment of debt, avoidance of further debt, or conversion of debt to equity, which can significantly mitigate financial risk and improve the reputation with investors and lenders.
- While the process of deleveraging might initially lead to slower growth due to fewer resources for investment, in the long-term perspective, it may help businesses become more sustainable and financially sound by improving their credit score and risk profile.
Importance
Deleveraging is an important finance term as it refers to the process by which a company or individual reduces its total financial leverage. The primary focus of deleveraging is minimising debt.
This is important because high levels of debt can expose a company or individual to various risks. If interest rates increase, debt repayments become costlier.
Also, high debt levels can lead to lower credit ratings and make borrowing more expensive in the future. By reducing financial liabilities, deleveraging can increase long-term financial stability and resilience, contributing to healthier balance sheets and overall financial performance.
Breathing room gained through deleveraging can also enable companies to invest in growth avenues, enhance shareholder value, or individuals to increase personal wealth.
Explanation
Deleveraging is a fundamental financial management strategy that companies and individuals use to reduce their total quantity of debt. This is accomplished by selling assets, reducing spending, or raising capital to pay off loans.
The primary purpose of deleveraging is to decrease risk and improve the overall financial health of an entity. It can also be used to increase the entity’s borrowing capacity in the future by improving its leverage ratio (total debt to equity), which is a key factor that lenders consider when determining creditworthiness.
From a business perspective, deleveraging can be seen as a conservative strategy aimed at improving financial stability and achieving a more sustainable growth path. By reducing liabilities, a company can protect itself from potential downside risks associated with high debt levels, such as elevated interest expenses and default risk.
On the other hand, individuals might use deleveraging as a strategy to improve their personal financial position, reduce stress related to high debt burdens, and increase financial flexibility. It’s important to note that while deleveraging can reduce financial risk and potential stress, it may also slow down growth since part of the capital that could otherwise be used for investment is used to repay debt.
Examples of Deleveraging
Individual Level: For example, John has a considerable amount of personal debt due to his mortgage, auto loan, and credit card. He decides to deleverage by cutting down on his expenses and using surplus money to gradually repay his debts. He also decides to sell his second car to repay loans. In this way, he reduces his debt and the overall financial risk he carries.
Corporate Level: Imagine a corporation that has huge debt on its balance sheet due to expansion into a new market or perhaps a merger or acquisition. However, the profits generated are not as much as anticipated, or the takeover doesn’t go as well as planned. The company decides to deleverage to reduce risk. It might do this by selling off assets, reducing expenditures, restructuring debt, or issuing equity to repay some of its debt. Microsoft did this in 2016 when it announced plans to deleverage after its acquisition of LinkedIn by reducing its debt.
National Level: After the 2008 financial crisis, many countries, including the United States and members of the European Union, had to deleverage to decrease the risk of another financial breakdown. This was done through austerity measures, which included reduced public spending and increased taxes, aimed at decreasing the debt-to-GDP ratio. As a result, these economies experienced a phase of deleveraging, which helped lower their overall debt levels and associated risk.
FAQs about Deleveraging
What is Deleveraging?
Deleveraging is the process by which 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 debts and obligations.
Why is Deleveraging important?
Deleveraging is an important aspect of finance because it can reduce the risk an entity faces in going into default. If a company is highly leveraged, small changes in the market or industry could lead to significant losses, that’s why it’s often seen as a risk mitigation tool.
What is Deleveraging in finance?
In finance, deleveraging refers to the reduction of the leverage ratio, or the percentage of debt in the balance sheet of a single economic entity, such as a household or a firm. It’s the opposite of leveraging, which means taking on more debt to finance investment.
What are the effects of Deleveraging?
When a company deleverages, it reduces the amount of debt it has, which decreases the risk of default. However, this also means they may have less capital to work with, potentially causing slower growth. Conversely, if an entire economy deleverages this may lead to slower growth for a period of time.
What is Global Deleveraging?
Global deleveraging refers to worldwide efforts to reduce excessive debt levels. This can be driven by governments, companies, and individuals collectively, and it can have significant effects on global growth and financial stability.
Related Entrepreneurship Terms
- Balance Sheet Reduction
- Capital Structure
- Debt-to-Equity Ratio
- Financial Leverage
- Asset Liquidation
Sources for More Information
- Investopedia – A widely recognized online resource for finance and investing definitions, news, and tutorials.
- Corporate Finance Institute – An educational entity that provides a range of free and paid courses on financial topics.
- Khan Academy – A nonprofit organization that provides free online education, including a large number of financial and economic topics.
- Bloomberg – A significant source of global business and financial news.
