

Financial Leverage And Capital Structure Policy  Financial Leverage
Financial leverage is the degree to which a company uses fixedincome securities such as debt and preferred equity. The more debt financing a company uses, the higher its financial leverage. A high degree of financial leverage means high interest payments, which negatively affect the company's bottomline earnings per share.
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. (Learn more about leverage in ETFs: Losing At Leverage and 5 Ways Debt Can Make You Money.)
Degree of Financial Leverage
The formula for calculating a company's degree of financial leverage (DFL) measures the percentage change in earnings per share over the percentage change in EBIT. DFL is the measure of the sensitivity of EPS to changes in EBIT as a result of changes in debt.
Formula:
DFL = percentage change in EPS or EBIT
percentage change in EBIT EBITinterest
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 is $100,000. If we increase Newco's EBIT by 20%, how much will the company's EPS increase?
Calculation and 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%. (For further reading, see Will Corporate Debt Drag Your Stock Down?)



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Degree Of Financial Leverage  ...
A ratio that measures the sensitivity of a company’s earnings ... 
Leverage Ratio
Any ratio used to calculate the financial leverage of a company ... 
Degree Of Operating Leverage  ...
A type of leverage ratio summarizing the effect a particular ... 
Leverage
1. The use of various financial instruments or borrowed capital, ... 
Earnings Before Interest & Tax ...
An indicator of a company's profitability, calculated as revenue ... 
Degree Of Combined Leverage  DCL
A leverage ratio that summarizes the combined effect the degree ...

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