In this blog, I’ve explained how to calculate the degree of financial leverage, but first, we will have to understand the theoretical part to understand the whole process. Knowing the theoretical part can help us interpret results later on after calculating the degree of financial leverage (DFL)
Table of Contents
- What is called the Degree of Financial Leverage (DFL)?
- What are the differences between the financial leverage and the degree of financial leverage?
- Why do we calculate the degree of financial leverage (DFL)?
- Calculating the degree of financial leverage
- The Degree of Financial Leverage Formula at the EBIT level:
- The degree of financial leverage formula at quantity level
- FAQS
What is called the Degree of Financial Leverage (DFL)?
The Degree of Financial Leverage (DFL) is a financial metric that measures how sensitive a company’s Earnings Per Share (EPS) is to changes in its operating profit (EBIT). Essentially, it shows how much the EPS will change for every 1% change in EBIT.
What are the differences between the financial leverage and the degree of financial leverage?
Financial leverage measures the use of debt in financing on the other hand DFL evaluates how sensitive a company’s net income or earnings per share (EPS) is to changes in operating income (EBIT). Understanding both concepts is crucial for assessing financial risk and making informed investment and financing decisions. The basic differences include:
- Definition: Financial leverage measures the amount of debt used in a company’s capital structure, while DFL shows how changes in EBIT affect net income or EPS.
- Purpose: Financial leverage looks at the use of debt in financing, while DFL measures earnings sensitivity to financial leverage.
- Formula: Financial leverage uses total debt and equity, whereas DFL uses EBIT and interest expenses.
- Risk Measurement: Financial leverage assesses overall debt risk; DFL shows how much profits can fluctuate due to leverage.
- Scope: Financial leverage is a static measure of capital structure; DFL is dynamic, indicating how profits react to changes in income.
- Impact: High financial leverage means more debt and high DFL means small income changes can cause large profit changes.
Why do we calculate the degree of financial leverage (DFL)?
- Measure Financial Risk: Helps assess the risk associated with using debt in the company’s capital structure.
- Understand Earnings Volatility: Indicates how much EPS will fluctuate with changes in operating income (EBIT), showing earnings stability.
- Evaluate Debt Impact: Analyze the impact of existing debt on shareholder returns and profitability.
- Support Decision-Making: Aids management in making informed financing and investment decisions based on risk tolerance.
- Investor Insight: Provides investors with an understanding of potential changes in returns, assisting in evaluating the company’s financial health.
Calculating the degree of financial leverage
The degree of financial leverage formula
This means that DFL shows the ratio of the percentage change in EPS to the percentage change in EBIT. A higher DFL indicates that the company is using more financial leverage, which means it is more dependent on debt.
There are two alternative ways to calculate the degree of financial leverage.
Alternative 1
The Degree of Financial Leverage Formula at the EBIT level:
Let’s break down what each term means:
- EBIT: Earnings Before Interest and Taxes. This is the company’s operating income before paying interest on debt.
- Interest (I): The fixed interest expenses that the company must pay on its debt.
Step-by-Step Explanation:
- Calculate EBIT: Find the company’s operating income (revenue minus operating expenses). This is the starting point, as it represents the company’s earnings from its core operations before any interest or taxes are considered.
- Subtract Interest Expenses: Deduct the fixed interest expenses from EBIT. This tells you the earnings left after paying interest on the company’s debt.
- Apply the Formula: Divide the original EBIT by the result obtained in Step 2 (EBIT – Interest). This ratio tells you how much the EPS will change for every 1% change in EBIT.
4. Interpret the Result: The higher the DFL, the more sensitive the company’s EPS is to changes in EBIT. This means that if the DFL is high, a small percentage change in EBIT will cause a larger percentage change in EPS.
Let’s understand the formula with an example:
Let’s say Company A has the following information:
- EBIT = $100,000
- Interest Expense = $20,000
Now, let’s calculate the DFL:
- Subtract Interest from EBIT:
EBIT−Interest=100,000−20,000
=80,000
2. Calculate the degree of financial leverage (DFL):
Interpret the result:
A DFL of 1.25 means that for every 1% change in EBIT, the EPS will change by 1.25% that amount. If EBIT increases by 10%, the EPS will increase by 12.5% (10% x 1.25).
Alternative 2
The degree of financial leverage formula at quantity level
Formula Explanation:
- Q: Quantity of units sold or produced.
- P: Price per unit.
- V: Variable cost per unit.
- FC: Fixed Costs.
- Int: Interest expenses.
Breaking down the formula:
- Calculate Contribution Margin:
Subtract the total variable costs from total sales revenue to get the contribution margin. The contribution margin shows how much is left after covering variable costs, which can then be used to cover fixed costs and generate profit
2. Calculate Earnings Before Interest and Taxes (EBIT):
Subtract fixed costs (FC) from the contribution margin. This gives you the EBIT, which is the profit before paying interest on debt and taxes.
3. Calculate Profit After Paying Interest:
Subtract interest expenses (Int) from EBIT. This tells you the profit left after paying interest on debt, which goes to the shareholders.
Let’s understand this DFL formula with an example:
Assumptions:
- Quantity of units sold (Q) = 500 units
- Price per unit (P) = $50
- Variable cost per unit (V) = $30
- Fixed Costs (FC) = $5,000
- Interest expense (Int) = $2,000
Calculate DFL:
This DFL value of 1.67 means that if EBIT changes by 1%, EPS will change by 1.67%. In other words, using debt has increased the sensitivity of earnings for shareholders.
There is also another way to calculate the degree of financial leverage
DOL at Sales
This process is not widely used but, it’s good to know.
As I’ve discussed both alternatives to calculating the degree of financial leverage, now it’s your time to practice both alternatives to find out and analyze the financial risk your company is facing.
In case you have any confusion or questions, write them in the comment box.
FAQS
1. What does a high degree of financial leverage indicate?
A high degree of financial leverage indicates that a company is significantly dependent on debt for its operations. This means even a small percentage change in Earnings Before Interest and Taxes (EBIT) can lead to a much larger percentage change in Earnings Per Share (EPS). While it can magnify profits during good times, it also increases the financial risk during downturns.
2. What does the degree of financial leverage measure?
The degree of financial leverage measures the sensitivity of a company’s Earnings Per Share (EPS) to changes in its operating income (EBIT). It reflects how effectively a company is using its fixed financial obligations, such as interest expenses, to enhance returns to shareholders.
3. What does the degree of financial leverage indicate?
The degree of financial leverage indicates how changes in a company’s EBIT will affect its EPS. It highlights the financial risk and the potential volatility in earnings resulting from the use of fixed financial costs, such as interest on debt.
4. How is the degree of financial leverage calculated?
The degree of financial leverage is calculated using the following formula:
Alternatively, it can also be calculated at the quantity level:
Where:
Where:
- Q = Quantity sold
- P = Price per unit
- V = Variable cost per unit
- FC = Fixed costs
- I = Interest expenses
5. Degree of financial leverage can best be described as:
The degree of financial leverage can best be described as a financial metric that shows how sensitive a company’s EPS is to changes in EBIT. It provides insight into the impact of fixed financial costs on shareholder returns and indicates the level of financial risk.
6. Can the degree of financial leverage be negative?
No, the degree of financial leverage cannot be negative because EBIT and interest expenses are absolute values. However, if EBIT becomes negative (indicating an operating loss), the company might face financial distress, but the DFL calculation in such cases becomes less meaningful since there are no positive earnings to amplify.