What is Deleveraging?

Deleveraging is the process of paying back debt in order to reduce the risk of default. This is most critical when management finds that the firm is in danger of not generating enough cash flow to meet its debt repayment obligations. This situation is especially common when economic conditions are declining, which drives a decline in sales. Another reason to deleverage is when a business shifts out of its initial growth phase, and so no longer needs as much debt to fund ongoing increases in its working capital requirements.

How to Deleverage

There are several ways to deleverage by raising cash. These alternatives include selling off assets, selling off an operating unit, selling shares in the business, lengthening payment terms to suppliers, shortening credit terms to customers, and accelerating the turnover of inventory. Another interesting approach is to do so from natural increases in your cash balance as your business switches over from growth mode to being a mature business. When a firm is in growth mode, it constantly needs more working capital to support its receivables and inventory. This is no longer the case when sales level off, resulting in a natural increase in the amount of cash on hand - which can be used to pay down debt.

Disadvantages of Deleveraging

The main disadvantage of deleveraging is that a business may need to sell off key assets in order to pay down debt. This can be a major hindrance over the long-term, when those assets might have been used to place the business in a better competitive position. Further, a forced deleveraging may result in assets being sold at inordinately low prices, because the firm does not have sufficient time to find all possible interested buyers. A further concern is that a rapid deleveraging process can give investors the impression that a business is in severe financial circumstances, which may trigger a general sell-off of its shares.