During times of economic pain, such as a recession or a depression, many companies, limited partnerships and individual families go through the process of deleveraging their balance sheets. Unless you have a background in economics or finance, you may not understand what deleveraging means or why it is so important.
What Is Deleveraging?
Deleveraging essentially comes down to reducing debt. More specifically, it means reducing the relative percentage, or the absolute dollar amount, of a balance sheet funded by debt. It can be accomplished either by generating more cash or selling off assets such as real estate, stocks, bonds, divisions, subsidiaries, etc. The objective of deleveraging is—most often—to reduce risk when the deleveraging is voluntary. It is also used to avoid bankruptcy when done as a result of a change in financial circumstances.
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 money is owned outright with no obligations against it. You can also fund assets through borrowing. For instance, taking out a mortgage on a house allows you to cover most of the purchase price, with the bank owning the rest.
Take someone who owns an asset, such as an original oil painting that costs $100,000. If the owner funds the entire purchase with shareholders’ equity or net worth, and the work of art increases in value by 10%, they are sitting on a $10,000 pre-tax gain. Likewise, if the value of the painting declines by 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 took out a one-year loan of $50,000 to fund the rest. 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 profit and the interest rate on the loan was 8%, then the percentage increase would be 12%.
- $10,000 profit - $4,000 interest = $6,000 net gain divided into $50,000 equity = .12, or 12%).
- $10,000 loss + $4,000 interest cost = -$14,000 total loss + $50,000 equity = $36,000 net funds = 28% loss.
What Makes Leverage Both Effective and Destructive?
This very mathematical relationship is what makes leverage so effective on the positive side and so destructive on the negative side. When a company or person deleverages, it is reducing the risk of absolute financial destruction if things go south. But, it is also reducing the upside of what they might earn when things are positive. Although it sometimes means giving up some potential gains, deleveraging 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 p.l.c., the British oil, and natural gas giant. After the Gulf of Mexico oil spill in 2010, the firm sold assets to raise $10 billion, shrinking its holdings and shoring up its cash reserves. These efforts allowed it to survive while paying tens of billions of dollars in fines and penalties.