Deleveraging essentially comes down to reducing 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.
Source: thebalance.com, “What Does Deleveraging Mean?
Why Companies Go for Borrowing (or Leverage)
Let’s say you buy an asset, a vintage car, worth $1,00,000. Over time, the value of the asset (the car) appreciates. Here are two scenarios where:
1. You buy the car entirely using equity
2. You split the cost where you pay half using equity and half by borrowing (debt)
By running the numbers, after one year, the return value of buying with the help of debt (leverage) is higher (112%) than buying entirely with equity (110%). Hence, it makes perfect sense to go for leveraging when assets are appreciating.
Why Deleveraging Makes Sense During Recession
However, the situation changes during a recession when the value of non-essential items (such as vintage cars) depreciates. Similar to the above, here are two scenarios:
3. You buy the car entirely using the equity
4. You split the cost 50-50 between equity and loan
In this case, the return value of buying entirely from equity is much higher (90%) than buying with the help of debt (72%).Hence during recession, if your assets are depreciating, it’s best to get rid of maximum debt.
During appreciation, leveraging makes sense.
During depreciation, deleveraging makes sense.
