What is a '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.
BREAKING DOWN '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.