Deleveraging

Deleveraging Meaning

Deleveraging is defined as the process where an organization slashes down its debt or financial leverage by either selling its own assets or raising equity capital. The prime goal of deleveraging is to curtail the proportionate percentage of the balance sheet of a business that is funded by its liabilities.

Numerical Example of Deleveraging

Let’s take an example of deleveraging. Let us assume, a business has $ 10, 00,000 of assets. The structure of finding the asset is as such that $5, 00,000 is covered by debt and the rest $5, 00,000 is covered by equity. The net income earned during the year was $2, 50,000. Considering this let’s calculate a few crucial ratios.

Now let us take a second scenario where deleveraging comes into play where the business has taken a decision to consume $2, 00,000 of its assets to pay $2, 00,000 of its debt. The business is now be left of $8, 00,000 out of which equity contribution remains the same as $5, 00,000 but the debt component has been reduced to $3, 00,000. On a similar occasion when the company has made a net income of $2, 50,000, let us see how the above-calculated ratio changes:

  • Debt to Equity = $3, 00,000 /$5, 00,000 = 60%
  • ROE (Return on Equity) = $2, 50,000/$5, 00,000 = 50%
  • ROA (Return on Assets) = $2, 50,000/$8, 00,000 = 31.2%

We can clearly see the second ratio looks much more financially healthy and profitable and also investors would also like to pick up the second option to put their money in.

Deleveraging

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Deleveraging Example – Practical Scenario

Freeport-McMoRan Inc. is an example of an organization that mainly dealt with mining that has implemented deleveraging recently. It had borrowed too much after the recession period, where its debt increased six times to more than $20 billion due to new business ventures.

The decline in prices of oil, however, compelled Freeport to change its plan. It started selling assets and making payments for the bonds, curtailing its overall debt to $11.1 billion. Also, it showed tremendous improvement to its EBITDA which almost got doubled in the second quarter from a year earlier than expected, bringing down the leverage of its cash flow to 1.4 times from 2.9 times.

Advantages of Deleveraging

Some of the advantages of deleveraging are as follows:

  • It can be considered as one of the effective methods to cut down debt without raising some additional loan/debt to cover up the present liability which many companies do and finally lands into a debt trap as what we call.
  • The company focuses on its own resources in the form of assets to cover up its pending liabilities. Thus there is no scope of any third part or external funding required. The entire debt structuring takes place based on the company’s potential.
  • The prime advantage of deleveraging is that it helps in reducing the risk i.e. voluntary deleveraging and also helps in avoiding bankruptcy when financial circumstances are as such.
  • When a company is involved in paying a huge penalty deleveraging it considered as the best option because it sells off its assets, shrinks its size of holding and also shores its cash reserve which allows it to at least survive in the market rather than getting shut down.

Disadvantages of Deleveraging

Some of the disadvantages of deleveraging are as follows:

  • An increasing systemic deleveraging can bring about the credit crunch and financial recession.
  • Deleveraging means turning down a lot of potential gains which could have been utilized earlier in more profitable ventures.
  • Deleveraging brings about layoffs, departmental shutdowns and also shrinkage of budgets which is not good at a practical point of view.
  • Deleveraging impacts the share prices of a company even maybe for a short span of time but to a great extent.
  • Deleveraging always does not go as planned because companies in the process to sell its assets, give away them at throwaway rates to cover up their debt.
  • Creditors get late payments or fewer payments over an extended period of time or at a lower interest rate.

Limitations of Deleveraging

Some of the limitations of deleveraging are as follows:

  • It can prove to be effective only when assets belonging to the company itself are monetized.
  • It always carries the risk of becoming disorderedly and sudden. The solutions being in short supply too.
  • There are very few indicators that the current practice of the utilization of leverage will diminish especially in the scenario of decreasing expectations for economic growth. Thus this calls the very purpose of utilization of deleveraging techniques at all.
  • Deleveraging shrinks the total intensification of market volatility on the balance sheet of the borrower. Furthermore, that ends up giving up prospective returns in good times, in barter for reduced risk of heavy loss along with unpleasant default in harsh times.

Important Points

  • Deleverage is to cutting down outstanding liabilities without incurring any new ones.
  • An increasing systemic deleveraging can bring about the credit crunch and financial recession.
  • The rate of savings can sometimes be linked to deleveraging as people/business tends to save more when they are not borrowing from the market.
  • Failure of deleveraging at times of need or financial crisis may increase the risk of default for a business.
  • Deleveraging is considered to be an effective strategy if it is implemented by monetizing the assets.

Conclusion

Considering a business view, deleveraging provides strength to balance sheets. It is an effective course of action to get a company back to its operation or provide a lifeline to it. From a practical scenario, however, deleveraging is not that great to look at. Job cuts, shutdowns, reducing budgets, and selling off assets are all the results of deleveraging where the business will seek to store the extra cash in order to pay off its obligations.

This has been a guide to what is deleveraging and it’s meaning. Here we discuss examples of deleveraging along with the practical scenarios, limitations, advantages, and disadvantages. You can learn more about fixed income from the following articles –

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