Degree of Financial Leverage

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Degree of Financial Leverage

Definition

The degree of financial leverage (DFL) measures how sensitive a company’s earnings per share (EPS) are to changes in operating income (EBIT) due to its use of debt. It expresses the percentage change in EPS for a given percentage change in EBIT and helps assess the risk and reward of a firm’s capital structure.

Key takeaways

  • A higher DFL means greater volatility in EPS for a given change in operating income — higher potential reward but more risk.
  • Firms with stable operating income can typically sustain higher financial leverage than firms with volatile earnings.
  • Industry norms vary: retail, airlines, utilities, and banking often display higher DFLs.
  • Excessive leverage has historically caused major failures (e.g., Lehman Brothers in 2008), so prudent management of debt is essential.

Formula

Two common ways to express DFL:

  1. Using percentage changes:
    DFL = (% change in EPS) / (% change in EBIT)

  2. Using EBIT and interest expense:
    DFL = EBIT / (EBIT − Interest)

This second form assumes interest expense is fixed and ignores taxes and other items that can affect EPS.

Interpretation and insights

  • DFL > 1 indicates EPS moves more than EBIT (amplification effect from fixed interest).
  • As interest expense rises or EBIT falls, DFL increases, making EPS more sensitive to EBIT swings.
  • DFL is useful for planning capital structure: management can estimate how additional debt will amplify EPS volatility.
  • Limitations: the basic DFL formula assumes constant interest, no taxes, and no changes in share count. It is most reliable for small-to-moderate changes around the current EBIT level; extreme changes can invalidate linear approximations.

Example

Assume BigBox Inc.:
* EBIT = $100 million
* Interest = $10 million
* Shares outstanding = 100 million
(Ignore taxes for clarity.)

Year 1 EPS = (EBIT − Interest) / Shares = (100 − 10) / 100 = $0.90

DFL = EBIT / (EBIT − Interest) = 100 / (100 − 10) = 100 / 90 ≈ 1.11

If EBIT increases by 20% (to $120 million), expected percentage change in EPS ≈ DFL × 20% = 1.11 × 20% = 22.2%.
Actual Year 2 EPS = (120 − 10) / 100 = $1.10, a 22.2% increase from $0.90.

If EBIT falls by 30% (to $70 million), EPS becomes (70 − 10) / 100 = $0.60, a 33.3% decline, consistent with DFL × (−30%) ≈ −33.3%.

Practical considerations

  • Combine DFL with operating leverage analysis to understand total risk exposure from both fixed operating costs and fixed financing costs.
  • Use DFL when modeling scenarios for financing decisions, but adjust for taxes, changing interest rates, and potential changes in share count.
  • Track industry benchmarks and volatility of operating income when deciding acceptable leverage levels.

Bottom line

DFL quantifies how debt amplifies changes in EPS relative to changes in operating income. It is a practical tool for evaluating capital-structure risk, but should be used alongside other financial analyses and with awareness of its simplifying assumptions.