Degree of Financial Leverage (DFL): Definition, Formula, Example and Analysis

In this article, we cover the degree of financial leverage. This includes the key definition, how to calculate the degree of financial leverage as well as example and analysis. Before, jumping into detail, let’s understand some key relevant definitions.

Definition

Let’s understand some key definition of financial leverage as well as the degree of financial leverage (DFL).

What is Financial Leverage?

Financial leverage is the potential use of fixed financial costs to magnify the effects of changes in earnings before interest and taxes on the firm’s earnings per share. 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.

There are two common fixed financial costs that we usually see in the income statement of a company. These are the interest on debt and preferred stock dividends. The interest on debt and preferred stock dividends are generally a must expenses to be reflected in the corporation’s income statement regardless of the amount of EBIT available to pay them. These two costs represent the total fixed financial costs of a corporation.

What is Degree of Financial Leverage (DFL)?

You already understood the financial leverage by now. Thus, let’s continue to understand about the degree of financial Leverage (DFL).

DFL is the numerical measure of a corporation’s financial leverage. Similarly to the degree of operating leverage, DFL represents the changes of two variables. These are the percentage change in earnings per share (EPS) and percentage change in earnings before interest and taxes (EBIT).

How to Calculate Degree of Financial Leverage?

As mentioned above, the degree of financial leverage (DFL) is measured by the changes of EPS over the changes of EBIT. Thus, DFL is calculated by dividing the percentage change in EPS and the percentage change in EBIT.

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We can summary the DFL formula as follow:

Degree of Financial Leverage (DFL) = Percentage change in EPS/ Percentage change in EBIT

Alternatively, we can calculate the degree of financial leverage at a given base level of EBIT by the following formula:

DFL at base level EBIT = EBIT/ [EBIT – I – (PD × 1/ (1 – T))]

Where:

PD = Preferred stock dividend

I = Interest on debt

T = Tax rate

Example

ABC Co is small food company expect its EBIT for current year of $10,000. The company has a $20,000 bond with annual 10% coupon rate. It also issues 600 shares of $4 annual preferred stock outstanding. The company also has 1,000 shares of common stock outstanding.

The annual interest on the bond is $2,000 ($20,000 × 10%). The annual dividends on the preferred stocks are $2,400 (1,000 shares × $4). Let’s assume that the tax rate is at 40%.

Calculate the degree of financial leverage (DFL) in two scenarios as follow:

  1. Case 1: 40% increase in EBIT
  2. Case 2: 40% decrease in EBIT

Solution

From the example above, 40% increase in EBIT is at $14,000 ($10,000 × 40%) while the 40% decrease in EBIT is at $6,000 ($10,000 × (100% – 40%)).

Therefore, we can summary into the tabular below:

 Case 2Current YearCase 1
 $$$
EBIT6,00010,00014,000
Less: Interest2,0002,0002,000
Net profits before taxes4,0008,00012,000
Less: Taxes (40%)1,6003,2004,800
Net profits after taxes2,4004,8007,200
Less: Preferred stock dividends2,4002,4002,400
Earnings available for common stock (EAC) (A)02,4004,800
Total common shares outstanding (B)1,0001,0001,000
Earnings per share (EPS) (C = A/B)02.404.80

From summary financial information above, we can calculate the degree of financial leverage as follow:

Degree of Financial Leverage (DFL) = Percentage change in EPS/ Percentage change in EBIT

Where:

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Percentage change in EPS and EBIT is calculated as follow:

Case 1:

Percentage change in EPS = (4.80 – 2.40)/2.40 = 100%

Percentage change in EBIT = (14,000 – 10,000)/10,000 = 40%

Case 2:

Percentage change in EPS = (0 – 2.40)/ 2.40 = -100%

Percentage change in EBIT = (6,000 – 10,000)/ 10,000 = -40%

Therefore, we can calculate the DFL for both cases as follow:

DFL cas1 1 = 100%/40% = 2.5

DFL case 2 = (-100%)/ (-40%) = 2.5

Alternatively, we can calculate the degree of financial leverage of a give base level of EBIT at $10,000by using the second formula as follow:

DFL at base level EBIT = EBIT/ [EBIT – I – (PD × 1/ (1 – T))]

Where:

Base level EBIT = $10,000

PD = $2,400

T = 40% at $10,000

I = $2,000

Therefore, DFL at $10,000 = 10,000/ [10,000 – 2,000 – (2,400 × 1/60%)] = 2.5

Analysis and Interpretation

The effect of financial leverage results from the changes in the firm’s EBIT. An increase in EBIT results in a more than proportional increase in EPS. Whereas, a decrease in EBIT results in a more than proportional decrease in EPS.

Whenever the percentage change in EPS as a result of the percentage change in EBIT is greater than the percentage change in EBIT or it is greater than 1; thus, financial leverage exists.

In both cases above, since the DFL is greater than 1, thus financial leverage does exist. The higher the value as calculated in both cases above, the greater the degree of financial leverage.

The calculation of this second formula is a more direct method of calculating the degree of financial leverage of a given base level of EBIT. It is probably is easier formula to calculate with considering the changes in both EBIT and EPS.

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The relationship between the two figures of both change in EPS and change in EBIT can be used to the alternative financing plan. This is done by examining the effect of EPS over a range of EBIT levels. The main objective is to determine the indifferent points of EBIT among a range of various financing plans that a company would choose.

Conclusion

The degree of financial leverage is an important indicator to measure the relative changes of EPS compare to changes in EBIT.

The value of the calculation greater than 1 indicates that there is greater degree of financial leverage.

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