

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?)
Modigliani And Miller's Capital Structure Theories

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. 
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. 
Small Business
Financial Leverage In Corporate Capital Structure
Corporate management uses financial leverage to increase earnings per share and returnonequity. 
Investing
Operating Leverage Captures Relationships
Find out how fixed and variable costs interact to shed new light on old companies. 
Investing
Debt Ratios
Learn about the debt ratio, debtequity ratio, capitalization ratio, interest coverage ratio and the cash flow to debt ratio. 
Investing
4 Leverage Ratios Used In Evaluating Energy Firms
Analysts use specific leverage ratios to compare firms within an industry. A basic understanding of these ratios helps when evaluating oil and gas stocks. 
Trading
The Basics of Forex Leveraging
A closer look at the controversial topic of leverage in forex trading. 
Investing
Explaining Leveraged Loans
Leveraged loans are loans extended to companies or people who already have large amounts of debt. 
Investing
Evaluating a Company's Capital Structure
Learn to use the composition of debt and equity to evaluate balance sheet strength. 
Investing
4 Leverage Ratios Used In Evaluating Energy Firms
These four leverage ratios can help investors understand how oil and gas firms are managing their debt.