Financial leverage can be defined as the degree to which a company uses fixed-income securities, such as debt and preferred equity. With a high degree of financial leverage come high interest payments. As a result, the bottom-line earnings per share is negatively affected by interest payments. As interest payments increase as a result of increased financial leverage, EPS is driven lower.

As mentioned previously, 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.

Degree of Financial Leverage
This measures the percentage change in earnings per share over the percentage change in EBIT. This is known as "degree of financial leverage" (DFL). It is the measure of the sensitivity of EPS to changes in EBIT as a result of changes in debt.

Formula 11.19
DFL = percentage change in EPS or EBIT
           percentage change in EBIT    EBIT-interest

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 amounts to $100,000 annually. If we increase Newco's EBIT by 20%, how much will the company's EPS increase?

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%.
Sales and Leverage

Related Articles
  1. Investing

    Operating Leverage Captures Relationships

    Find out how fixed and variable costs interact to shed new light on old companies.
  2. Small Business

    Financial Leverage In Corporate Capital Structure

    Corporate management uses financial leverage to increase earnings per share and return-on-equity.
  3. Investing

    Reinvesting Capital Gains In Leveraged Portfolios

    Don't get forced into action. Learn how to plan properly to avoid making rash decisions.
  4. Investing

    Leverage: Is It Good for Your Portfolio?

    Discover the concept of financial leverage. Learn multiple ways to get leverage in your portfolio, and decide if leverage is a good idea for you.
  5. Managing Wealth

    Leveraging Leverage For Bigger Profits

    Leverage is like fire. Find out how to use it to heat up your investing without burning your portfolio.
  6. Financial Advisor

    Why Leveraged ETFs Are Not a Long-Term Bet

    Leveraged ETFs aren't for the average investor. They can, however, present significant upside potential for the right type of trader.
  7. Trading

    Forex Leverage: A Double-Edged Sword

    Find out how this flexible and customizable tool magnifies both gains and losses.
  8. Investing

    The Hidden Danger of Leveraged ETFs

    Leveraged ETFs pose several dangers for retail investors tempted by potential high returns in a short period of time.
Frequently Asked Questions
  1. What is a good annual return for a mutual fund?

    Learn the key factors that determine if a mutual fund's return is "good" for you and your needs?
  2. How are industrial goods different from consumer goods?

    Understand the difference between industrial goods and consumer goods, and learn the different types of industrial goods ...
  3. What causes inflation, and does anyone gain from it?

    In this article, we will examine the fundamental factors behind inflation, different types of inflation and who benefits ...
  4. What is the difference between a buy-side analyst and a sell-side analyst?

    The main difference between a buy-side analyst and sell-side analyst is the type of firm that employs them and the people ...
Trading Center