Loading the player...

What is a 'Degree of Financial Leverage - DFL'

Degree of Financial Leverage (DFL) is a ratio that measures the sensitivity of a company’s earnings per share (EPS) to fluctuations in its operating income, as a result of changes in its capital structure. Degree of Financial Leverage (DFL) measures the percentage change in EPS for a unit change in earnings before interest and taxes (EBIT), and can be mathematically represented as follows:

How to calculate degree of financial leverage
DFL can also be represented by the equation below:

How to calculate degree of financial leverage

BREAKING DOWN 'Degree of Financial Leverage - DFL'

The higher the DFL, the more volatile earnings per share (EPS) will be. Since interest is a fixed expense, leverage magnifies returns and EPS, which is good when operating income is rising, but can be a problem during tough economic times when operating income is under pressure.

Consider the following example to illustrate the concept. Assume hypothetical company BigBox has operating income or earnings before interest and taxes (EBIT) of $100 million in Year 1, with interest expense of $10 million, and has 100 million shares outstanding. (For the sake of clarity, let’s ignore the effect of taxes for the moment.)

EPS for BigBox in Year 1 would therefore be:

Degree of Financial Leverage (DFL) is:

This means that for every 1% change in EBIT or operating income, EPS would change by 1.11%.

Now assume that BigBox has a 20% increase in operating income in Year 2. Note that interest expense remains unchanged at $10 million in Year 2 as well. EPS for BigBox in Year 2 would therefore be:

In this instance, EPS has increased from 90 cents in Year 1 to $1.10 in Year 2, which represents a change of 22.2%.

This could also be obtained from the DFL number = 1.11 x 20% (EBIT change) = 22.2%.

If EBIT had decreased instead to $70 million in Year 2, what would have been the impact on EPS? EPS would have declined by 33.3% (i.e. DFL of 1.11 x -30% change in EBIT). This can be easily verified, since EPS in this case would have been 60 cents, which represents a 33.3% decline.

DFL, therefore, is invaluable in helping a company assess the amount of debt or financial leverage it should opt for in its capital structure. If operating income is relatively stable, then earnings and EPS would be stable as well, and the company can afford to take on a significant amount of debt. However, if the company operates in a sector where operating income is quite volatile, it may be prudent to limit debt to easily manageable levels.

  1. Leverage

    The use of various financial instruments or borrowed capital, ...
  2. Earnings Before Interest & Tax ...

    Earnings Before Interest & Taxes (EBIT) is an indicator of a ...
  3. Operating Leverage

    Operating leverage is a measurement of the degree to which a ...
  4. Maximum Leverage

    The maximum size of a trading position permitted through a leveraged ...
  5. Gross Leverage Ratio

    Gross leverage ratio is the sum of an insurance company’s net ...
  6. Times Interest Earned - TIE

    Times interest earned (TIE) is a metric used to measure a company's ...
Related Articles
  1. Investing

    Calculating Degree of Financial Leverage

    Degree of financial leverage (DFL) is a metric that measures the sensitivity of a company’s operating income due to changes in its capital structure.
  2. 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.
  3. Trading

    How Much Leverage Is Right for You in Forex Trades

    It isn’t economics or global finance that trip up first-time forex traders. Instead, a basic lack of knowledge on how to use leverage is at the root of trading losses.
  4. Trading

    Leverage's 'Double-Edged Sword' Need Not Cut Deep

    Learn to cut out leverage losses quickly, leaving profits room to grow.
  5. Investing

    4 Leverage Ratios Used In Evaluating Energy Firms

    These four leverage ratios can help investors evaluate how energy manage their debt.
  6. Investing

    Dissecting Leveraged ETF Returns

    These funds are a relatively new product to most investors, but they could be what you need for increased returns.
  7. Investing

    Leverage: Increasing your real estate net worth

    Few homeowners think of their mortgages as leverage, but careful use of this asset can help them maximize their net worth.
  8. Investing

    Understanding Taxation On Leveraged ETFs (YCS)

    Read about the potential tax implications for investors of leveraged exchange-traded funds, or ETFs, and learn why leveraged ETF taxation can be so complicated.
  9. Investing

    UPS Stock: Capital Structure Analysis

    Analyze UPS' capital structure to determine the relative importance of debt and equity financing. Identify the factors influencing financial leverage trends.
  10. Investing

    Hedge Fund Failures Illuminate Leverage Pitfalls

    Learn what mistakes cause hedge funds to collapse and how to avoid similar problems.
  1. How does degree of financial leverage (DFL) affect earnings per share (EPS)?

    Learn about degree of financial leverage, how to calculate a company's DFL and how the DFL affects earnings per share. Read Answer >>
  2. How is EBIT breakeven affected by leverage and financing plans?

    Read about how financial leverage increases the break-even point for a corporation, which is the point at which earnings ... Read Answer >>
  3. What is the difference between operating leverage and financial leverage?

    Discover the two equity valuation metrics, operating leverage and financial leverage, how they are similar and what differentiates ... Read Answer >>
  4. How do I calculate the degree of operating leverage?

    The degree of operating leverage is a measure used to evaluate how a company's operating income changes with respect to a ... Read Answer >>
  5. How do you find the level of EBIT where EPS doesn't change?

    Learn about the relationship between earnings before interest and taxes (EBIT and earnings per share (EPS) and how to find ... Read Answer >>
  6. How can a firm bring down its operating leverage?

    Discover how to determine a company's operating leverage and how this metric can be helpful to analysts and investors when ... Read Answer >>
Hot Definitions
  1. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  2. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
  3. Income Statement

    A financial statement that measures a company's financial performance over a specific accounting period. Financial performance ...
  4. Leverage Ratio

    A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt, or ...
  5. Annuity

    An annuity is a financial product that pays out a fixed stream of payments to an individual, primarily used as an income ...
  6. Restricted Stock Unit - RSU

    A restricted stock unit is a compensation issued by an employer to an employee in the form of company stock.
Trading Center