Degree Of Financial Leverage - DFL
Definition of 'Degree Of Financial Leverage - DFL'
A ratio that measures the sensitivity of a company’s earnings per share (EPS) to fluctuations in its operating income, as a result of changes in its capital structure. Degree of Financial Leverage (DFL) measures the percentage change in EPS for a unit change in earnings before interest and taxes (EBIT), and can be mathematically represented as follows:
DFL can also be represented by the equation below:
The ratio shows that the higher the degree of financial leverage, the more volatile is EPS. Since interest is a fixed expense, leverage magnifies returns and EPS, which is good when operating income is rising, but it can be a problem during tough economic times when operating income is under pressure.
Investopedia explains 'Degree Of Financial Leverage - DFL'
Consider the following example to illustrate the concept. Assume hypothetical company BigBox has operating income or EBIT of $100 million in Year 1, with interest expense of $10 million, and has 100 million shares outstanding. (For the sake of clarity, let’s ignore the effect of taxes for the moment.)
EPS for BigBox in Year 1 would therefore be:
Degree of Financial Leverage (DFL) is:
This means that for every 1% change in EBIT or operating income, EPS would change by 1.11%.
Now assume that BigBox has a 20% increase in operating income in Year 2. Note that interest expense remains unchanged at $10 million in Year 2 as well. EPS for BigBox in Year 2 would therefore be:
In this instance, EPS has increased from 90 cents in Year 1 to $1.10 in Year 2, which represents a change of 22.2%.
This could also be obtained from the DFL number = 1.11 x 20% (EBIT change) = 22.2%.
If EBIT had decreased instead to $70 million in Year 2, what would have been the impact on EPS? EPS would have declined by 33.3% (i.e. DFL of 1.11 x -30% change in EBIT). This can be easily verified, since EPS in this case would have been 60 cents, which represents a 33.3% decline.
DFL therefore is invaluable in helping a company assess the amount of debt or financial leverage it should opt for in its capital structure. If operating income is relatively stable, then earnings and EPS would be stable as well, and the company can afford to take on a significant amount of debt. However, if the company operates in a sector where operating income is quite volatile, it may be prudent to limit debt to easily manageable levels.
Articles Of Interest
The amount of debt and equity that makes up a company's capital structure has many risk and return implications.
Solvency and liquidity are equally important for a company's financial health. A number of financial ratios are used to measure a company’s liquidity and solvency, and an investor should use ...
Large amounts of debt can cause businesses to become less competitive and, in some cases, lead to default. To lower their risk, investors use a variety of leverage ratios - including the debt, ...
Learn to use the composition of debt and equity to evaluate balance sheet strength.
These four leverage ratios can help investors understand how oil and gas firms are managing their debt.
Learn how to use revenue and expenses, among other factors, to break down and analyze a company.
NOI is a long-run profitability measure that smart investors can count on.
Companies can manipulate their numbers, so you need to learn how to determine the accuracy of EPS.
Borrowed funds can mean a leg up for companies, or the boot for investors. Find out how to tell the difference.
In finance, the term leverage arises often. Both investors and companies employ leverage to generate greater returns on their assets. However, using leverage does not guarantee success, and the ...