Degree of Financial Leverage Guide 2025: Definition, Formula

These are the percentage change in earnings per share (EPS) and percentage change in earnings before interest and taxes (EBIT). Highly leveraged companies may face significant financial problems during a recession because their operating income will rapidly decline and, thus, so will their overall profitability. Unlike the balance sheet metric financial leverage, the “degree” of financial leverage is concerned solely with the income statement.

When does a company increase its degree of financial leverage?

• As can be seen in the formulas below, the degree of financial leverage can be calculated from the income statement alone.
• Enrolling in finance courses is beneficial for deepening your understanding and enhancing your strategic financial skills.
• With an MBA in Finance and over 17 years in financial services, Kishore Kumar has expertise in corporate finance, mergers, acquisitions, and capital markets.
• On the other hand, a low DFL indicates that EPS has less fluctuations with change in operating income, therefore lower financial risk.

Knowing the right amount of debt is key to assessing a company’s financial health and its ability to profit from borrowing. The degree of financial leverage depends on several factors that shape a company’s financial risk and return profile. Understanding these factors is crucial for making informed financial decisions.

He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem. This DFL of 1.25 means that for every 1% change in EBIT, EPS will change by 1.25%. Master the skills to connect with customers confidently, understand their needs, and make each sale a success. With practical product insights, empathy, and proven strategies, you will be ready to impress and land the job you want. This post delves into the mechanics of this DFL formula, its implications, and practical applications in business scenarios.

Highly leveraged companies are particularly vulnerable to drops in operating income since their fixed costs remain constant. Companies such as Peloton which recorded high growth during the early months of the COVID-19 pandemic leveraged on debt to finance their growth. This led to some very high interest expenses which greatly affected the EBIT of the company. The DFL enables us to comprehend how these fixed interest costs impact on fluctuations of net income compared to fluctuations of EBIT.

Example of Degree of Financial Leverage

The degree of financial leverage formula offers profound insights into a company’s financial health and risk profile. By quantifying how changes in operating income affect the earnings per share, the degree of financial leverage formula helps make critical financial decisions. It is important to understand the concept of the degree of financial leverage because it indicates the relationship between the capital structure of a company and its operating income. A low ratio is indicative of the low percentage of debt in a company’s capital structure, which again indicates that the sensitivity of the net income to the fluctuation in operating income is low.

Formula 2: Degree of Financial Leverage = % Change in EPS / % Change in EBIT

For instance, if the DFL is 2, then it means that you get 2 times the free capital. The degree of financial leverage formula measures how a company’s earnings per share (EPS) responds to changes in its operating income, revealing the impact of using fixed-cost financing. For investors, the degree of financial leverage formula offers a clear indication of the risk-return profile of their investments.

This assists in maintaining the cost of servicing the debt low and constant in the event that market rates go up thus stabilizing cash flows. DFL is obtained by using the formula, the percentage change in EPS divided by the percentage change in operating income. A high DFL means that a small change in operating income can lead to a larger change in EPS, in other words, high financial risk.

Debt also brings in interest as a sunk cost and this makes the impact of any changes in EBIT on net income even bigger. The degree of financial leverage (DFL) refers to net income sensitivity to the fluctuation caused by a change in the capital structure. It revolves around the concept used to evaluate the amount of debt that a company is required to repay. Revenue volatility significantly impacts DFL by influencing operating income stability.

The interest that a company has to pay on its debt or financial degree of financial leverage liabilities is a fixed expense. For example, in Year 1, ABC International has no debt and earns $40,000 before interest and taxes. Therefore, the degree of financial leverage is 1.00, which is quite conservative. The result is earnings before interest and taxes of $70,000, while $20,000 of interest expense reduces the earnings before taxes to $50,000. This means that the degree of financial leverage has increased to $70,000 / $50,000, or 1.4.

What Is The Degree of Financial Leverage Formula?

Organizations should strive to have smooth cash flows in order to meet the interest charges and the redemption of the debts. This can be done through proper management of working capital, improving operating efficiency to cut on expenses and ensuring a good and steady cash inflow. Effective cash flow management is a protective shield against fluctuations in the economy and other costs that might arise from time to time. Hence, it is crucial to balance the risks arising from high financial leverage for the stability of a company’s finances. It is possible to reduce negative effects and make sure that using leverage leads to increased profits without putting pressure on the financial situation. On the other hand, DFL also reveals that there exist higher returns for the firms.

By the end, you will have a solid grasp of this essential financial metric and its significance in managing a company’s finances. It is important not to have too much leverage, and therefore, a debt to equity ratio should be kept moderate. Debt on the other hand is a better hedge against risks and the firm uses it while also maintaining a healthy stock of equity. This balance is achieved through the process of reviewing and changing capital structure periodically depending on the market conditions. Financial leverage is the use of debt to finance assets in an organization’s balance sheet with the view of increasing the rate of returns on equity.

Which Fluctuations in Financial Leverage Indicators Should Attract the Attention of the Company’s Management?

• Financial leverage is concerned with the relationship between a company’s earnings before interest and taxes (EBIT) and its earnings per share (EPS) of common stock.
• This improves the return on equity and the profitability which makes high leverage desirable during the growth phase.
• Hence, it is crucial to balance the risks arising from high financial leverage for the stability of a company’s finances.
• However, the risks are significantly increased during downturns, potentially leading to severe financial distress or even bankruptcy.
• Decisions regarding expansion, investment in new projects, or contraction are better informed when the potential impacts on leverage are clearly understood.

This is because fixed debt costs imply that as more revenues are earned, net income is boosted, thereby expediting the EPS growth rate. Leverage has the effect of potentially large profits in a favorable environment as demonstrated by the above companies. Enrolling in finance courses is beneficial for deepening your understanding and enhancing your strategic financial skills. These courses will equip you with the knowledge to apply complex formulas like the degree of financial leverage effectively, supporting informed decision-making and sophisticated financial planning.

DFL is used in evaluating the risk that is inherent in the capital structure of a particular firm. High financial leverage thus implies that the firm is exposed to fluctuations in operating income because even if total revenues fluctuate, total costs for interest do not. Decline in operating income does not bring down these costs and therefore, a steeper decline in net income and EPS is observed. Therefore, it can be inferred that a high DFL indicates a higher risk of financial distress particularly during economic downturn or in sales volatility. DFL is invaluable in helping a company assess the amount of debt or financial leverage it should opt for in its capital structure.

How often should DFL be calculated?

They should also take the stability and the growth of the company’s earnings into account to assess the risks and the returns of investment. During the same year, as the demand for home fitness equipment rose, Peloton’s EBIT rose considerably. This rise when combined with its high DFL had a resultant effect on net income which rose at a much faster rate. The company used fixed costs to achieve higher levels of profitability and illustrate how financial leverage can improve the business returns when it experiences growth.

However, this same leverage heightens risks during downturns or periods of volatile revenue, as fixed costs can erode profitability. The degree tells the firm how likely it is for it to be burdened with financial liabilities. The degree of financial leverage (DFL) measures the impact of fixed financial costs on EPS. It is calculated as the percentage change in EPS divided by the percentage change in operating income. This relationship reveals how variations in operating income influence net income due to fixed financial obligations, such as interest expenses. Effective debt management is facilitated by regular analysis of the degree of financial leverage formula.

Updating the financial models and stress testing as well as conducting the sensitivity analysis is very useful in order to identify and prepare for the risks. Such an approach helps to be ready for the unfavorable situation and make changes in the strategy when necessary. Leverage also assists in the correct financing mix as a company in a bid to reduce the cost of capital assets. One advantage is that the interest charged on the debt is tax on the other hand, dividends on equity are tax, which is advantageous. In this article, we’ll break down what financial leverage is, how to calculate it, what it means for businesses, and how to manage the risks involved.