The degree of financial leverage (DFL) is a ratio used in corporate finance to measure the sensitivity of earnings per share (EPS) to the fluctuation in the operating income (also called earnings before interest and taxes or EBIT). The effect of financial leverage emerges if a company uses debt financing. Interest payments on fixed-income securities are fixed and affect the EPS (the higher they are, the lower the EPS). Thus, the fluctuation of EPS varies to a greater extent than fluctuation of EBIT.
The DFL ratio shows the percentage change in EPS in response to a 1% change in EBIT!
Low vs. High Financial Leverage
Low financial leverage indicates a low proportion of debt in a company’s capital structure, which means both lower financial risk and lower sensitivity of EPS to fluctuation in EBIT. Other things being equal, such companies are more stable and less sensitive to changes in operating income.
High financial leverage means a high proportion of debt in a company’s capital structure. Such companies are exposed to greater financial risk, and stockholders’ return is highly volatile. So, such companies are more responsive to changes in operating income.
The degree of financial leverage ratio is the percentage change in earnings per share (EPS) over the percentage change in earnings before interest and taxes (EBIT).
The percentage change in EPS is the change in EPS (∆EPS) over EPS.
In turn, the change in EPS can be calculated as follows:
Here ∆EBIT is a change in EBIT, ∆I is a change in the interest payment, and T is a tax rate. Because the interest payment is fixed, change in the interest payment is equal to zero (∆I=0).
The EPS is calculated as follows:
Here I represents the interest payment, and N is a number of preferred stocks outstanding.
Thus, the percentage change in EPS can be defined as follows:
The percentage change in EBIT is the change in EBIT over the EBIT.
So, the degree of financial leverage can be calculated using the following formula.
Degree of financial leverage and preferred stock
If a company has preferred stocks outstanding, the formula above must be modified, taking into account preferred dividends. In this case, earnings per share are found as follows:
Here D is preferred dividends, and N is a number of preferred stocks outstanding. So the change in earnings per share is
where ∆D is the change in preferred dividends. As interest (I) and preferred dividends (D) are constant, hence ∆I=0 and ∆D=0.
The percentage change in EPS can be determined as follows:
Thus, the degree of financial leverage ratio adjusted to preferred dividends is
Two companies have the same EBIT of $3,000,000 but different capital structure. Company Y is mostly focused on equity financing using both common and preferred equity. Its preferred dividend payment is $150,000, and the interest payment is $250,000. By contrast, Company Z tends to use debt financing and has only common equity. Its interest payment is $1,250,000. The tax rate for both companies is 30%.
The degree of financial leverage of Company Y is 1.18 and 1.71 for Company Z.
Thus, Company Z is more sensitive to fluctuations in EBIT than Company Y. For example, if EBIT of both companies rises by 5%, the EPS of Company Y will increase by 5.9% (5 × 1.18), and the EPS of Company Z will increase by 8.55% (5 × 1.71). In contrast, the drop in EBIT by 10% will lead to a decrease in the EPS of Company Y by 11.8% and by 17.1% for Company Z.