What Does Deleveraging Mean?

Deleveraging
Deleveraging is the process of reducing the ratio, or absolute amount, of debt relative to equity for the purposes of either decreasing risk or making required payments to avoid bankruptcy. Richard Goerg / Photographer's Choice RF / Getty Images

During times of economic pain, such as a recession or a depression, many companies, limited partnerships, and individual families willingly or forcibly go through the process of deleveraging their balance sheets.  Unless you have a background in economics or finance, you may not understand what this term means or why it is so important.  

Deleveraging essentially comes down to reducing the relative percentage, or the absolute dollar amount, of a balance sheet funded by debt.

 It can be accomplished either by generating cash internally from operations (in the case of a corporation) or working (in the case of a person) or selling off assets such as real estate, stocks, bonds, divisions, subsidiaries, etc.  The objective of deleveraging is to most often to reduce risk (when the deleveraging is voluntary) or avoid bankruptcy (when the deleveraging is done as a result of a change in financial circumstance).

To understand the mechanics of deleveraging, you need to understand that assets on a balance sheet must be funded by something. In many cases, the safest funding source is shareholders’ equity or net worth. This is money owned outright with no obligations against it. Other sources of funding include debt (for instance, taking out a mortgage on a house allows you to the cover most of the purchase price with money belonging to the bank's depositors) and float, which is cash and other assets you hold but don’t own (a property and casualty insurance company that is allowed to invest the money it receives from policyholders even though it only gets to keep the capital until it’s time to pay out as policies come due (cars wrecked, property destroyed, etc.) is a good illustration).

Take someone who owns an asset, such as an original oil painting that costs $100,000. If he or she funds the entire purchase with shareholders’ equity, or net worth, and the work of art increases in value 10%, they are sitting on a $10,000 pre-tax gain. Likewise, if the value of the painting declines 10%, they experience a $10,000 pre-tax loss.

 

Now, imagine the purchase price was funded 50% with equity and 50% debt - that is, they put $50,000 down and borrowed the other $50,000.  The same increase or decrease would cause double the gain or loss in percentage terms less the cost of the borrowed funds.  If it took a year to sell the painting at a gain (let’s ignore taxes for now) and the interest rate was 8%, then the percentage increase would be 18.4% ($10,000 gain - $800 interest = $9,200 net gain divided into $50,000 equity = .184, or 18.4%). The loss would be 21.6% ($10,000 loss + $800 interest cost = $10,800 total loss - $50,000 equity = $39,200 net funds = 21.6% loss).

This very mathematical relationship is what makes leverage so effective on the positive side and so destructive on the negative side. The process of deleveraging is designed to reduce the total amplifying effect of volatility and the absolute capital destruction when things go south. Although it sometimes means giving up the potential of upside gains, it takes a lot of risk off the table so the focus can be on fixing the underlying business or catching your financial breath.

A famous example of deleveraging in the past decade was BP, plc, the British oil and natural gas giant.

 After the gulf oil spill, the firm sold tens of billions of dollars in assets, shrinking the size of its holdings and shoring up its cash reserves.  This allowed it to survive while paying tens of billions of dollars in fines and penalties.