Fundamental analysis uses the 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. The high level of interest payments negatively affects EPS.
Degree of Financial Leverage
The DFL determines the percentage change in a company's EPS per unit change in its EBIT. A company's DFL is calculated by dividing a company's percentage change in EPS by the percentage change in EBIT over a certain period. It could also be calculated by dividing a company's EBIT by its EBIT less interest expense.
Earnings per Share
EPS is used in fundamental analysis 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 average outstanding shares.
How the Degree of Financial Leverage Affects Earnings Per Share
A higher DFL ratio means that the company's EPS is more volatile. For example, assume hypothetical company ABC has EBIT of $50 million, an interest expense of $15 million and outstanding shares of 50 million in its first year. Company ABC's resulting EPS is 70 cents, or ($50 million - $15 million) / (50 million).
In its second year, company ABC had 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). Company ABC's resulting DFL is 1.33 (400%/300%), or (($3.5 - $0.7)/$0.7) / (($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%.