Financial leverage can help a company increase returns by using debt properly, but it can also raise financial risk. In this blog, we explain the degree of financial leverage, what it means, why it matters, how to calculate it, and how to interpret the result. We also include examples to show how it works.
What is the Degree of Financial Leverage?
The degree of financial leverage measures how a company’s Earnings Per Share (EPS) changes in response to changes in its Earnings Before Interest and Taxes (EBIT). It provides insight into how a firm’s financial structure, particularly its use of debt, impacts its profitability and risk.
A higher degree of financial leverage means that a company has a greater reliance on debt financing, which can magnify both profits and losses. This can help during growth when EBIT is increasing, as it boosts EPS. However, it can also increase the risk of financial distress if EBIT declines.
Understanding the degree of financial leverage is crucial for management and investors. It helps evaluate a company’s financial risk tied to its capital structure and helps decide the right balance of debt and equity financing for profitability and risk management.
What is Financial Leverage?
Financial leverage refers to the strategy of using borrowed funds (such as loans or debt securities) to increase the potential return on investment. This increases both gains and losses. By using leverage, a company or investor can control a larger asset base with a smaller amount of their own capital.
This can enhance profitability when returns are positive, but it also increases the risk of magnified losses if investments perform poorly. Effective management of financial leverage is important for balancing risk and return in financial decision-making.
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Importance of the Degree of Financial Leverage
The degree of financial leverage is important for several reasons, including:
- Risk Assessment: The degree of financial leverage allows companies and investors to measure the financial risk associated with a specific capital structure. A higher DFL suggests that a company relies more on debt, which can magnify profits but also increase the risk of financial distress in the event of declining earnings.
- Decision-Making: Determining the optimal mix of debt and equity financing is critical. Companies must strike a balance between using debt to leverage returns and avoiding excessive risk. Understanding DFL helps in making informed decisions about the right amount of debt to employ.
- Profitability Analysis: Financial leverage measures how changes in a company’s operating income (EBIT) impact its earnings per share (EPS). By calculating DFL, companies can assess their profit potential under different operating scenarios. This helps in identifying the sensitivity of EPS to fluctuations in EBIT.
- Investor Perspective: Investors use the degree of financial leverage as part of their due diligence process. It helps them understand how sensitive a company’s earnings and stock price are to changes in the economic environment. A high DFL may attract risk-tolerant investors seeking potentially higher returns, while a low DFL may appeal to risk-averse investors.
- Strategic Planning: Leverage analysis is a critical component of corporate financial planning. It guides strategic decisions about capital structure, investment strategies, and risk management. By managing DFL effectively, companies can align their financial structure with their overall goals and risk tolerance.
The degree of financial leverage (DFL) can be calculated using different formulas, but the most common ones include:
1. Degree of Financial Leverage = % Change in Net Income / % Change in EBIT
It measures how sensitive net income is to fluctuations in EBIT. A higher DFL implies that small changes in EBIT can lead to significant changes in net income.
2. Degree of Financial Leverage = % Change in EPS / % Change in EBIT
EPS is a measure of a company’s profitability on a per-share basis. Given that the number of outstanding shares can also have an impact on changes in net income, it evaluates how changes in EBIT affect the company’s EPS.
3. Degree of Financial Leverage = EBIT / (EBIT – Interest)
This formula shows how sensitive earnings available to shareholders are to changes in EBIT because of interest expense. A higher DFL means a small change in EBIT can cause a larger change in earnings.
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How to Calculate Degree of Financial Leverage
Use the following steps to calculate the degree of financial leverage by using the specified formulas:
- Step 1: Determine the net income for a particular year from the income statement. To calculate the percentage change in net income, subtract the previous year’s net income from the current year’s net income, and then divide the result by the net income of the previous year.
- % Change in Net Income = [(Net Income Current Year – Net Income Previous Year) / Net Income Previous Year] * 100%
- Step 2: Determine the EBIT (Earnings Before Interest and Taxes) for a particular year by adding net income to interest and taxes, all of which are line items from the income statement. To calculate the percentage change in EBIT, take the EBIT of the current year, subtract the EBIT from the previous year, and then divide this difference by the EBIT from the previous year.
- % Change in EBIT = [(EBIT Current Year – EBIT Previous Year) / EBIT Previous Year] * 100%
- Step 3: Finally, calculate the Degree of Financial Leverage by dividing the percentage change in net income (from step 1) by the percentage change in EBIT (from step 2).
- Degree of Financial Leverage = % Change in Net Income / % Change in EBIT
- Step 1: Determine the EPS for a particular year from the company’s financial statements. Calculate the percentage change in EPS by subtracting the EPS of the previous year from that of the current year and then dividing the result by the EPS of the previous year.
- % Change in EPS = [(EPS Current Year – EPS Previous Year) / EPS Previous Year] * 100%
- Step 2: Determine the EBIT (Earnings Before Interest and Taxes) for a particular year as explained in Formula 1.
- Step 3: Calculate the Degree of Financial Leverage by dividing the percentage change in EPS (from step 1) by the percentage change in EBIT (from step 2).
- Degree of Financial Leverage = % Change in EPS / % Change in EBIT
- Step 1: Determine the EBIT for a particular year by adding interest expense and taxes to the net income.
- EBIT = Net income + Interest expense + Taxes
- Step 2: Calculate the difference between EBIT and the interest expense to find the Earnings Before Taxes (EBT).
- EBT = EBIT – Interest Expense
- Step 3: Calculate the Degree of Financial Leverage by dividing the EBIT (from step 1) by the difference between EBIT and the interest expense (from step 2).
- Degree of Financial Leverage = EBIT / (EBIT – Interest Expense)
Or
- Degree of Financial Leverage = EBIT / EBT
Example of Degree of Financial Leverage
Let’s look at some simple examples to understand the formula for the degree of financial leverage:
Example 1: Consider Company ABC Inc., which reported a net income of $600,000 for the current fiscal year compared to $500,000 in the prior year. In the current year, the company had interest expenses of $75,000 and paid $120,000 in taxes. In the previous year, the interest expenses were $60,000, and the tax bill amounted to $110,000. Calculate the Degree of Financial Leverage (DFL) for Company ABC Inc.:
| Particulars | Current Year | Previous Year |
|---|
| Net Income | $600,000 | $500,000 |
| Interest Expense | $75,000 | $60,000 |
| Taxes Paid | $120,000 | $110,000 |
To calculate the Degree of Financial Leverage (DFL) for Company ABC Inc., you need to follow these steps:
1. Calculate the percentage change in Net Income:
- % Change in Net Income = [(Net Income Current Year – Net Income Previous Year) / Net Income Previous Year] * 100%
- % Change in Net Income = [($600,000 – $500,000) / $500,000] * 100%
- % Change in Net Income = ($100,000 / $500,000) * 100%
- % Change in Net Income = 0.20 or 20%
2. Calculate the percentage change in EBIT (Earnings Before Interest and Taxes):
Firstly, calculate EBIT for both years:
- EBIT Current Year = (Net Income Current Year + Interest Current Year + Taxes Current Year)
- EBIT Current Year = ($600,000 + $75,000 + $120,000)
- EBIT Current Year = $795,000
- EBIT Previous Year = (Net Income Previous Year + Interest Previous Year + Taxes Previous Year)
- EBIT Previous Year = ($500,000 + $60,000 + $110,000)
- EBIT Previous Year = $670,000
Now calculate the percentage change in EBIT:
- % Change in EBIT = [(EBIT Current Year – EBIT Previous Year) / EBIT Previous Year] * 100%
- % Change in EBIT = [($795,000 – $670,000) / $670,000] * 100%
- % Change in EBIT = ($125,000 / $670,000) * 100%
- % Change in EBIT = 0.18657 or 18.66% (rounded to two decimal places)
3. Now, use the DFL formula to calculate the Degree of Financial Leverage:
- Degree of Financial Leverage = (% Change in Net Income / % Change in EBIT)
- Degree of Financial Leverage = (0.20 / 0.18657)
- Degree of Financial Leverage = 1.07 (rounded to two decimal places)
This indicates that a 1% change in EBIT would result in a 1.07% change in net income due to the company’s financial leverage.
Example 2: Let’s consider another company, XYZ Inc. This company reported a net income of $720,000 for the current fiscal year, compared to $600,000 in the prior year. In the current year, the company had earnings before interest and taxes (EBIT) of $1,200,000 and an interest expense of $120,000.
In the previous year, earnings before interest and taxes (EBIT) were $1,000,000, with an interest expense of $100,000. The company has 100,000 outstanding shares. Calculate the Degree of Financial Leverage (DFL) for XYZ Inc. based on this financial information.
| Particulars | Current Year | Previous Year |
|---|
| Earnings Before Interest and Taxes (EBIT) | $1,200,000 | $1,000,000 |
| Interest Expense | $120,000 | $100,000 |
| Net Income | $720,000 | $600,000 |
| Number of Outstanding Shares | 100,000 | 100,000 |
To calculate the Degree of Financial Leverage (DFL) for Company XYZ Inc., you’ll need to follow these steps:
1. Calculate the EPS for both years before any changes:
- EPS Current Year = Net Income / Number of Outstanding Shares
- EPS Current Year = $720,000 / 100,000
- EPS Current Year = $7.20 per share
- EPS Previous Year = Net Income / Number of Outstanding Shares
- EPS Previous Year = $600,000 / 100,000
- EPS Previous Year = $6 per share
2. Calculate the % change in EPS:
- % Change in EPS = [(EPS Current Year – EPS Previous Year) / EPS Previous Year] * 100%
- % Change in EPS = [($7.20 – $6.00) / $6.00] * 100%
- % Change in EPS = (1.20 / 6.00) * 100%
- % Change in EPS = 20%
3. Calculate the % change in EBIT
- % Change in EBIT = [(EBIT Current Year – EBIT Previous Year) / EBIT Previous Year] * 100%
- % Change in EBIT = [($1,200,000 – $1,000,000) / $1,000,000] * 100%
- % Change in EBIT = ($200,000 / $1,000,000) * 100%
- % Change in EBIT = 20%
4. Now, use the DFL formula to calculate the Degree of Financial Leverage:
- Degree of Financial Leverage = (% Change in EPS / % Change in EBIT)
- Degree of Financial Leverage = (20 / 20)
- Degree of Financial Leverage = 1
The Degree of Financial Leverage (DFL) is 1.
Example 3: Consider the case of ABC Inc., a different company, which reported a net income of $300,000 in its most recent annual financial statement. They incurred an interest expense of 6% on their outstanding debt of $1,500,000 and paid $30,000 in taxes. Calculate the Degree of Financial Leverage (DFL) for ABC Inc.
| Particulars | Amount |
|---|
| Interest rate | 6% |
| Outstanding debt | $1,500,000 |
| Net income | $300,000 |
| Interest expense | $90,000 |
| Taxes paid | $30,000 |
To calculate the Degree of Financial Leverage (DFL) for Company ABC Inc., you’ll need to follow these steps:
1. Calculate the Interest expense:
- Interest expense = Interest rate * Outstanding debt
- Interest expense = 6% * $1,500,000
- Interest expense = $90,000
2. Calculate the EBIT for the particular year
- EBIT = Net income + Interest expense + taxes paid
- EBIT = $300,000 + $90,000 + $30,000
- EBIT = $420,000
3. Calculate the EBT for the particular year
- EBT = EBIT – Interest Expense
- EBT = $420,000 – $90,000
- EBT = $330,000
4. Now, use the DFL formula to calculate the Degree of Financial Leverage
- Degree of Financial Leverage = EBIT / EBT
- Degree of Financial Leverage = ($420,000 / $330,000)
- Degree of Financial Leverage = 1.27
Therefore, a 1% change in EBIT can cause a 1.27% change in earnings available to equity holders.
Conclusion
The Degree of Financial Leverage is a powerful tool for businesses to evaluate their financial risk and make informed decisions about their capital structure. By understanding DFL, companies can effectively balance the advantages of financial leverage with the potential downsides.
As companies aim for financial success, the Degree of Financial Leverage (DFL) remains important in financial planning and risk analysis. Advance your finance career with our CFO course tailored for future leaders!
Frequently Asked Questions
Q1. What is the difference between financial leverage and operating leverage?
Financial leverage shows how debt affects earnings. Operating leverage shows how fixed operating costs affect profit.
Q2. Why is the degree of financial leverage important?
The degree of financial leverage helps companies and investors understand financial risk. It shows how debt can increase both returns and losses.
Q3. How do you calculate the degree of financial leverage?
You can calculate the degree of financial leverage by dividing the percentage change in EPS by the percentage change in EBIT. You can also use the formula EBIT / (EBIT – Interest).
Q4. What does a high degree of financial leverage mean?
A high degree of financial leverage means a small change in EBIT can cause a bigger change in earnings. It shows that the company depends more on debt.
Q5. What does a low degree of financial leverage mean?
A low degree of financial leverage means changes in EBIT have a smaller effect on earnings. It shows that the company uses less debt and faces lower financial risk.