Deleverage - Explained
What is Deleverage?
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What is Deleverage?
Deleveraging is the process of reducing the debt of financial liabilities of a form, household or individual. This is the opposite of leveraging. The process of decreasing the financial leverage or debt of a firm by paying off all outstanding (existing) debts is deleveraging. When a company uses deleveraging, it aims to clear off all existing debts without incurring any further debts. A firm or an individual can cut down its financial leverage by selling its assets to pay back or raising capital through other means different from debt financing. Deleveraging helps to reduce the overall liabilities on a company's balance sheet and prevent the company from incurring new debts.
Back to:BUSINESS & PERSONAL FINANCE
How Does Deleverage Work?
Typically, a business has a combination of debt financing and equity financing on which it runs its operations. Individuals in certain cases use debt financing to assets, properties or even make investments. Debt is otherwise called financial leverage, companies take on huge debts to foster growth and also initiate large projects. Financial leverage, if not controlled, can increase and even pose risks of default. Also, when a company survives only on financial leverage or through debt sustainability, such a company has high risks, to the extent that it can become insolvent in the future time. Deleveraging is a process of reducing the overall financial leverage of a company or recorded or liabilities on a company's balance sheet. When used by a firm or individual, deleveraging does not yield immediate results. In the actual sense, it can take up to two years or more before the impacts of deleveraging are felt. One process in deleveraging entails a company or an individual selling off its assets so as to raise sufficient funds to finance business operations and use the remaining amount to pay off some parts of the debts owed. In the process of elimination or reducing liabilities, it is essential that the company or individual does not incur additional debts. This requires the availability of sufficient capital to fund its operations. If a firm is unable to deleverage, the level of debt can increase, making the firm more risky or vulnerable. Here are the major about to know about deleveraging;
- Deleveraging is a process of reducing or eliminating ones debts without incurring new ones.
- To deleverage, a company or individual must raise sufficient capital (i.e by selling its assets, equipment, stock, bond, and others). The capital raised will be used in financing the business operations and to also reduce the financial leverage.
- Deleveraging helps to reduce the number of liabilities that appear on a company's balance sheet.
- When deleveraging is excessively used, it can lead to a credit crunch or financial recession.
Company ABC is a big company whose assets operations are funded by equity and debt financing. For instance, the company has $15,000,000 in assets of which $8,000,000 worth of assets are funded by debt. Company ABC needs to reduce its financial leverage otherwise called debts and decide to use the deleveraging method. Using the method, the company can decide to dell some of its assets and use the proceeds to reduce the financial liabilities on its balance sheet. For instance, if $7,000,000 worth of assets are sold to repay leverage, it means that the company has $8,000,000 assets left, of which $1,000,000 is funded by debts. Deleveraging has some negative effects despite its enormous benefits in helping companies and individuals reduce their debts. The major disadvantages of deleveraging are;
- Deleveraging, when used by many people at the same time can create financial depression or credit crunching.
- When too many people clear off their dents and do not incur new debts, the economy can suffer.
- Excessive use of deleveraging is often associated with a downward spiral movement in the economy.