Fundamental analysis uses degree of financial leverage (DFL) to determine the sensitivity of a company's earnings per share (EPS) when there is a change in its earnings before interest and taxes (EBIT). When a company has a high DFL, it generally has high interest payments, which negatively impact EPS.
Degree of Financial Leverage
DFL determines the percentage change in a company's EPS per unit change in its EBIT. A company's DFL is calculated by dividing its percentage change in EPS by the percentage change in EBIT over a certain period. It can also be calculated by dividing a company's EBIT by its EBIT less interest expense.
Earnings per Share
EPS is used to determine a company's profitability. EPS is calculated by subtracting dividends paid out to shareholders from a company's net income. The resulting value is divided by the company's outstanding shares.
How the Degree of Financial Leverage Affects Earnings Per Share
A higher DFL ratio means a company's EPS is more volatile. For example, assume Company ABC in its first year has EBIT of $50 million, an interest expense of $15 million and 50 million outstanding shares. Company ABC's resulting EPS is 70 cents, or ($50 million – $15 million) ÷ 50 million shares.
In its second year, Company ABC has EBIT of $200 million, an interest expense of $25 million and outstanding shares of 50 million. Its resulting EPS is $3.50, or ($200 million – $25 million) ÷ 50 million shares.
Company ABC's resulting DFL is 1.33, or 400% ÷ 300%.
Or, [($3.50 – $0.70) ÷ $0.70] ÷ [($200 million – $50 million) ÷ $50 million].
Therefore, if the company's EBIT increases or decreases by 1%, the DFL indicates its EPS increases or decreases by 1.33%.