What it means
Leverage means using borrowed money to increase the size of what you can invest, which raises returns when things go well and losses when they do not. Deleveraging is the deliberate reversal of that position, shrinking the debt side of the balance sheet so that a bad year does less damage.
Companies deleverage for identifiable reasons rather than out of caution alone. Rising interest rates make existing debt more expensive to refinance, covenant pressure from lenders forces action, and a downturn in earnings makes a once-comfortable debt load suddenly look heavy.
There are four practical routes, and most businesses use more than one. Repay debt from operating cash, sell non-core assets and use the proceeds, suspend dividends and retain earnings, or issue new shares and use the money to pay down borrowings.
The trade-off is real and often underestimated. Every dollar used to repay debt is a dollar not spent on growth, so aggressive deleveraging can protect a balance sheet while quietly conceding market share to competitors who are still investing.
The measure of progress is usually a ratio rather than an absolute number. Debt-to-equity and net debt to EBITDA are the two most watched, and lenders typically set covenant targets in those terms, which is why deleveraging plans are written against ratio milestones instead of dollar amounts.
In practice
Real-world examples.
Example
A hotel group facing refinancing at 9% instead of 5% sells two regional properties for $18,000,000 and repays debt. Its net debt to EBITDA falls from 5.2 times to 3.4 times, which is enough to secure the refinancing on acceptable terms.
Example
A family-owned manufacturer suspends its $600,000 annual dividend for three years and applies the cash to loan repayment. The owners accept lower income in exchange for a debt-to-equity ratio falling from 1.8 to 0.9 and a materially lower risk of covenant breach.
Example
A retail chain issues $25,000,000 of new shares and uses the proceeds to retire high-cost debt. Existing shareholders are diluted, but the annual interest saving of roughly $2,300,000 and the removal of a refinancing cliff persuade them to support the raise.
Formula
Calculation
Debt-to-equity ratio = total debt / total equity. Net debt to EBITDA = (total debt - cash) / EBITDA.
A distribution business carries $8,000,000 of debt against $4,000,000 of equity, pays 8% interest, and generates EBITDA of $2,000,000. It holds no surplus cash.
Debt-to-equity before = $8,000,000 / $4,000,000 = 2.0
Net debt to EBITDA before = $8,000,000 / $2,000,000 = 4.0 times
Annual interest before = $8,000,000 x 0.08 = $640,000
The company sells a warehouse it no longer needs for $3,000,000, at book value so equity is unchanged, and uses every dollar to repay debt.
Debt-to-equity after = $5,000,000 / $4,000,000 = 1.25
Net debt to EBITDA after = $5,000,000 / $2,000,000 = 2.5 times
Annual interest after = $5,000,000 x 0.08 = $400,000
Interest falls by $640,000 - $400,000 = $240,000 a year, which flows straight into pre-tax profit. The cost is a smaller asset base and the loss of whatever the warehouse would have contributed, so the deleveraging is worth it only if that contribution was below $240,000 a year.Case study
Seen in the real world.
Kestrel Fabrication is an illustrative, fictional metalwork business created to show deleveraging under pressure. It had borrowed $12,000,000 to fund three acquisitions in two years, against equity of $5,000,000, giving a debt-to-equity ratio of 2.4 and interest of $840,000 a year at 7%.
When a major client cut orders, EBITDA fell from $3,000,000 to $1,900,000 and net debt to EBITDA rose from 4.0 times to 6.3 times, breaching a covenant set at 4.5 times. The lender granted a twelve-month waiver on condition that Kestrel presented a plan to return below 4.0 times.
The plan combined three actions: selling a surplus site for $2,500,000, suspending dividends worth $500,000 a year, and applying $1,000,000 of operating cash to repayment over the year. Debt fell to $8,000,000, and with EBITDA recovering to $2,100,000 the ratio came in at 3.8 times, which cleared the covenant in this fictional example and left the company with less capacity for the next acquisition.
Watch out
Common mistakes.
- Assuming less debt is always better. Some leverage lowers the overall cost of capital because interest is usually tax deductible, and a business with no debt at all may be underusing a cheap funding source.
- Deleveraging by cutting investment in the highest-returning parts of the business. Repaying an 8% loan with cash that would have earned 20% in the core operation destroys value even though the balance sheet looks tidier.
- Measuring progress only by the debt balance. Ratios move with earnings too, so a company can repay debt all year and still see its leverage ratio worsen if EBITDA falls faster.
Questions
People also ask.
What is a sensible level of leverage?
It depends on how stable the cash flows are, with utilities and property comfortably carrying more debt than cyclical manufacturers or early-stage businesses.
Is deleveraging always a defensive move?
Not necessarily, since some companies deliberately reduce debt to create capacity for a planned acquisition or to secure a better credit rating.
How quickly should a business deleverage?
Fast enough to satisfy lenders and remove refinancing risk, but not so fast that it starves operations, which is why most plans run over two to three years.
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