when deleveraging goes wrong
wall street can greet a successful deleveraging favorably for instance announcements of major layoffs can send share prices rising however deleveraging doesn t always go as planned when the need to raise capital to reduce debt levels forces firms to sell off assets that they don t wish to sell at fire sale prices the price of a company s shares generally suffers in the short run worse yet when investors get the feeling that a company is holding bad debts and unable to deleverage the value of that debt plummets even further companies are then forced to sell it at a loss if they can sell it at all inability to sell or service the debt can result in business failure firms that hold the toxic debt of failing companies can face a substantial blow to their balance sheets as the market for those fixed income instruments collapses such was the case for firms holding the debt of lehman brothers prior to its 2008 collapse economic effects of deleveragingborrowing and credit are integral pieces of economic growth and corporate expansion when too many people and firms decide to pay off their debts all at once and not take on any more the economy can suffer although deleveraging is typically good for companies if it occurs during a recession or an economic downturn it can limit credit growth in an economy as companies deleverage and cut their borrowing the downward spiral in the economy can accelerate as a result the government is forced to step in and take on debt leverage to buy assets and put a floor under prices or to encourage spending this fiscal stimulus can come in a variety of forms including buying mortgage backed securities to prop up housing prices and encourage bank lending issuing government backed guarantees to prop up the value of certain securities taking financial positions in failing companies providing tax rebates directly to consumers subsidizing the purchase of appliances or automobiles through tax credits or a host of similar actions the federal reserve can also lower the federal funds rate to make it less expensive for banks to borrow money from each other push down interest rates and encourage the banks to lend to consumers and businesses 2 taxpayers are usually responsible for paying off federal debt when governments bail out businesses that have suffered and are going through the deleveraging process examples of deleveraging and financial ratiosfor example let s assume company x has 2 000 000 in assets of which 1 000 000 is funded by debt and 1 000 000 is funded by equity during the year company x earns 500 000 in net income or profit although there are many financial ratios available to measure a company s financial health three of the key ratios that we ll be using are outlined below below are the ratio calculations using the financial information from company x instead of the above scenario assume that at the beginning of the year the company decided to use 800 000 of assets to pay off 800 000 of liabilities in this scenario company x would now have 1 200 000 in assets of which 200 000 is funded by debt and 1 000 000 is funded by equity if the company made the same 500 000 during the course of the year its return on assets return on equity and debt to equity values would be as follows the second set of ratios show the company to be much healthier and investors or lenders would thus find the second scenario more favorable 