What is Leverage? What is Deleveraging?

There are several financial related terminologies that are entering into common use. One such term is leverage. Both leverage and deleverage are used to show the financial situation of a company.

Background information

For a company, there are two types of funds to finance its activities. First is equity capital or money put by the owner/shareholder. Second is the money obtained through debt (borrowings). Companies generally use debt to finance because funds from shareholders may not be enough. At the same time, there is a limit up to which you can borrow as debt servicing is difficult. Too much debt may lead the company to a crisis.

What is leverage?

Leverage simply means fusing borrowed money to acquire assets. A company borrowing money from market or financial institutions (we can call it as debt) to create assets like building, machineries or even to acquire another firm are the common examples for leverage. The dependence on debt, given the size (assets) of a company readily shows its debt orientation or dependence and thus is an indicator of risk. To measure this debt dependence, we can use leverage ratio.

What is leverage ratio?

Leverage ratio is the ratio of debt to assets. It shows a company’s debt levels. A high financial leverage ratio shows that the company is using debt to finance its assets. Common types of leverage ratio are debt-equity ratio and debt ratio.

The formula for debt ratio is:

Debt Ratio = Total Debt / Total Assets

What is deleveraging?

Deleveraging is the act of reducing debt by selling own assets ore by using internally available funds. In this sense, deleveraging is the opposite of leveraging.

What is deleveraging?

Deleveraging is the act of reducing the amount of debt by using internal resources. It is thus paying back the debt. Here, cash should be generated internally. Own funds or selling off assets like building, real estate, stocks, bonds, divisions, subsidiaries, etc. are methods for deleveraging.

In economics, both leverage and deleverage for institutions and companies indicate particular macroeconomic situations. Too much leverage for the country’s corporate or financial system is a warning signal. As a corrective step, deleveraging should be implemented to reduce the riskiness of leverage. Leveraging is risk taking while deleveraging is risk reduction.