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%.