As mentioned previously, financial risk is the risk to the stockholders that is caused by an increase in debt and preferred equities in a company's capital structure. As a company increases debt and preferred equities, interest payments increase, reducing EPS. As a result, risk to stockholder return is increased. A company should keep its optimal capital structure in mind when making financing decisions to ensure any increases in debt and preferred equity increase the value of the company.
Degree of Financial Leverage
This measures the percentage change in earnings per share over the percentage change in EBIT. This is known as "degree of financial leverage" (DFL). It is the measure of the sensitivity of EPS to changes in EBIT as a result of changes in debt.
DFL = percentage change in EPS or EBIT
percentage change in EBIT EBIT-interest
Example: Degree of Financial Leverage
With Newco's current production, its sales are $7 million annually. The company's variable costs of sales are 40% of sales, and its fixed costs are $2.4 million. The company's annual interest expense amounts to $100,000 annually. If we increase Newco's EBIT by 20%, how much will the company's EPS increase?
The company's DFL is calculated as follows:
DFL = ($7,000,000-$2,800,000-$2,400,000)/($7,000,000-$2,800,000-$2,400,000-$100,000)
DFL = $1,800,000/$1,700,000 = 1.058
Given the company's 20% increase in EBIT, the DFL indicates EPS will increase 21.2%.
Sales and Leverage
InvestingDegree of financial leverage (DFL) is a metric that measures the sensitivity of a company’s operating income due to changes in its capital structure.
TaxesEarnings before interest and taxes, or EBIT, takes a company’s revenue, or earnings, and subtracts its cost of goods sold and operating expenses.
InvestingThe amount of debt and equity that makes up a company's capital structure has many risk and return implications.
Small BusinessCorporate management uses financial leverage to increase earnings per share and return-on-equity.
InvestingFind out how fixed and variable costs interact to shed new light on old companies.
InvestingOperating leverage tells investors about the relationship between a company's fixed and variable costs. The higher a company's fixed costs in relation to its variable costs, the greater its operating ...
InvestingDon't get forced into action. Learn how to plan properly to avoid making rash decisions.
Personal FinanceLeveraging your money can have many perks, but it's not always the smartest financial plan.
InvestingLeveraged loans are loans extended to companies or people who already have large amounts of debt.
InvestingDiscover the concept of financial leverage. Learn multiple ways to get leverage in your portfolio, and decide if leverage is a good idea for you.