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.



comments powered by Disqus
Hot Definitions
  1. Joint Venture - JV

    A business arrangement in which two or more parties agree to pool their resources for the purpose of accomplishing a specific task. This task can be a new project or any other business activity. In a joint venture (JV), each of the participants is responsible for profits, losses and costs associated with it.
  2. Aggregate Risk

    The exposure of a bank, financial institution, or any type of major investor to foreign exchange contracts - both spot and forward - from a single counterparty or client. Aggregate risk in forex may also be defined as the total exposure of an entity to changes or fluctuations in currency rates.
  3. Organic Growth

    The growth rate that a company can achieve by increasing output and enhancing sales. This excludes any profits or growth acquired from takeovers, acquisitions or mergers. Takeovers, acquisitions and mergers do not bring about profits generated within the company, and are therefore not considered organic.
  4. Family Limited Partnership - FLP

    A type of partnership designed to centralize family business or investment accounts. FLPs pool together a family's assets into one single family-owned business partnership that family members own shares of. FLPs are frequently used as an estate tax minimization strategy, as shares in the FLP can be transferred between generations, at lower taxation rates than would be applied to the partnership's holdings.
  5. Yield Burning

    The illegal practice of underwriters marking up the prices on bonds for the purpose of reducing the yield on the bond. This practice, referred to as "burning the yield," is done after the bond is placed in escrow for an investor who is awaiting repayment.
  6. Marginal Analysis

    An examination of the additional benefits of an activity compared to the additional costs of that activity. Companies use marginal analysis as a decision-making tool to help them maximize their profits. Individuals unconsciously use marginal analysis to make a host of everyday decisions. Marginal analysis is also widely used in microeconomics when analyzing how a complex system is affected by marginal manipulation of its comprising variables.
Trading Center