What is debt reduction?
Debt reduction is when a company or an individual tries to reduce their total financial leverage. In other words, it is debt reduction. The most direct way for an entity to deleverage is to immediately repay all existing debts and obligations on its balance sheet. If this is impossible, the company or the individual may be in a situation of increased risk of default.
Debt reduction means paying debts without incurring new ones.
Leverage (or debt) has become an integral aspect of our society. At the most basic level, companies use it to finance their operations, finance expansions and pay for research and development. By using debt, companies can pay their bills without issuing more shares, preventing shareholder profits from being diluted.
For example, if a company is incorporated with an investment of $ 5 million from investors, the company’s equity is $ 5 million – the money the company uses to operate. If the company also incorporates debt financing by borrowing $ 20 million, the company now has $ 25 million to invest in capital budgeting projects and more opportunities to increase the value for the fixed number of shareholders.
Companies often take on excessive debt to start growth. However, the use of leverage significantly increases the risk of the business. If the leverage does not continue to grow as expected, the risk may become too heavy for a company to bear. In these situations, all the business can do is deleverage by paying off its debt. Debt reduction can be a wake-up call for investors who need growth in their businesses.
The objective of deleveraging is to reduce the relative percentage of a company’s balance sheet that is funded by liabilities. Essentially, this can be accomplished in two ways. First, a business or individual can raise funds through commercial operations and use this excess cash to eliminate liabilities. Second, existing assets such as equipment, stocks, bonds, real estate, commercial weapons, to name a few, can be sold and the resulting proceeds can be used to repay debt. In both cases, the debt part of the balance sheet will be reduced.
The personal savings rate is an indicator of deleveraging because people save more money than they borrow.
Wall Street can welcome a successful deleveraging. For example, announcements of major layoffs can increase share prices. However, deleveraging does not always go as planned. When the need to raise capital to reduce the level of debt forces companies to sell assets they do not want to sell at inflammatory selling prices, the price of a company’s shares generally suffers in the short term.
Worse still, when investors feel that a company has bad debts and is unable to deleverage, the value of this debt collapses even more. Companies are then forced to sell it at a loss if they can sell it. Failure to sell or repay debt can result in the bankruptcy of a business. Companies that hold the toxic debt of bankrupt businesses can suffer a big blow to their balance sheets as the market for these fixed income securities collapses. This was the case for companies holding Lehman Brothers’ debt before its collapse in 2008.
Key points to remember
- Debt reduction is about reducing the stock of debt without taking on new debt.
- Debt reduction aims to reduce the relative percentage of a company’s balance sheet funded by liabilities.
- Too much systemic deleveraging can lead to a financial recession and a credit crunch.
Examples of debt reduction and financial ratios
For example, suppose Company X has $ 2,000,000 in assets, of which $ 1,000,000 is financed by debt and $ 1,000,000 is financed by equity. During the year, Company X made a net profit of $ 500,000. In this scenario, the return on the company’s assets, the return on equity and the debt values are as follows:
- Return on assets = $ 500,000 / $ 2,000,000 = 25%
- Return on equity = $ 500,000 / $ 1,000,000 = 50%
- Equity debt = $ 1,000,000 / $ 1,000,000 = 100%
Instead of the above scenario, suppose that at the start of the year, the company decided to use $ 800,000 in assets to repay $ 800,000 in liabilities. In this scenario, Company X would now have $ 1,200,000 in assets, of which $ 200,000 is financed by debt and $ 1,000,000 is financed by equity. If the company made the same $ 500,000 in the year, its return on assets, return on equity and debt values would be as follows:
- Return on assets = $ 500,000 / $ 1,200,000 = 41.7%
- Return on equity = $ 500,000 / $ 1,000,000 = 50%
- Equity debt = $ 200,000 / $ 1,000,000 = 20%
The second set of ratios shows that the business is much healthier, so investors or lenders would find the second scenario more favorable.
Negative effects of deleveraging
Borrowing and credit are an integral part of economic growth and business development. When too many people and businesses decide to pay off their debts in one go and stop paying them, the economy can suffer. When deleveraging creates a downward spiral in the economy, the government is forced to intervene.
Governments go into debt (leverage) to buy assets and put a floor below prices or to encourage spending. This can take a variety of forms, including buying mortgage-backed securities to support house prices and encourage bank lending, issuing government-backed guarantees to support the value of certain securities, taking financial positions in bankrupt businesses, offer tax rebates directly to consumers, by subsidizing the purchase of household appliances or automobiles through tax credits, or a multitude of similar actions.
Taxpayers are required to pay down the federal debt when the corporate sector deleverages because the government cannot accept excessive leverage.
The Federal Reserve can also lower the federal funds rate to make it cheaper for banks to borrow money, lower interest rates, and encourage banks to lend to consumers and companies.