Financial leverage can be defined as the degree to which a company uses fixed-income securities, such as debt and preferred equity. With a high degree of financial leverage come high interest payments. As a result, the bottom-line earnings per share is negatively affected by interest payments. As interest payments increase as a result of increased financial leverage, EPS is driven lower.

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.

Formula 11.19

DFL = percentage change in EPS or EBIT
           percentage change in EBIT    EBIT-interest
A shortcut to keep in mind with DFL is that, if interest is 0, then the DLF will be equal to 1.

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?

Answer:
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

Related Articles
  1. Taxes

    EBIT (Earnings Before Interest and Taxes)

    Earnings before interest and taxes, or EBIT, takes a company’s revenue, or earnings, and subtracts its cost of goods sold and operating expenses.
  2. Investing

    The Optimal Use Of Financial Leverage In A Corporate Capital Structure

    The amount of debt and equity that makes up a company's capital structure has many risk and return implications.
  3. Investing

    Reinvesting Capital Gains In Leveraged Portfolios

    Don't get forced into action. Learn how to plan properly to avoid making rash decisions.
  4. Trading

    How Much Leverage Is Right for You in Forex Trades

    It isn’t economics or global finance that trip up first-time forex traders. Instead, a basic lack of knowledge on how to use leverage is at the root of trading losses.
  5. Financial Advisor

    Understanding The Leverage Ratio

    Learn more on how the leverage ratio is used to calculate a company's ability to meet financial obligations and how changes in output will affect operating income.
  6. Investing

    Leverage: What It Is And How It Works

    Leverage is an investment strategy of using borrowed money to generate outsized investment returns. Before getting into greater detail on how leverage works in an investment context, it is useful ...
  7. Trading

    Forex Leverage: A Double-Edged Sword

    Find out how this flexible and customizable tool magnifies both gains and losses.
  8. Investing

    Debt Ratios

    Learn about the debt ratio, debt-equity ratio, capitalization ratio, interest coverage ratio and the cash flow to debt ratio.
  9. Investing

    UPS Stock: Capital Structure Analysis

    Analyze UPS' capital structure to determine the relative importance of debt and equity financing. Identify the factors influencing financial leverage trends.
Frequently Asked Questions
  1. Where else can I save for retirement after I max out my Roth IRA?

    The first option to explore is to determine if you can contribute to a 401(k), 403(b), or 457 plan at work. If your employer ...
  2. How did George Soros "break the Bank of England"?

    In Britain, Black Wednesday (September 16, 1992) is known as the day that speculators broke the pound. They didn't actually ...
  3. What counts as "debts" and "income" when calculating my debt-to-income (DTI) ratio?

    It's important to know your debt-to-income ratio because it's the figure lenders use to measure your ability to repay the ...
  4. Who are Monsanto's main competitors?

    Learn about Monsanto Company's two main operating divisions and its main competitors within each sector, including The Mosaic ...
Trading Center