Degree of Financial Leverage Formula

The degree of financial leverage formula calculates the change in net income occurring because of change in earnings before interest and taxes of the company. It helps determine how sensitive the company’s profit is to the changes in the capital structure. The higher this degree of financial leverage, the more volatile the earnings of a firm are.

The degree of financial leverage (DFL) refers to net income sensitivity to the fluctuation caused by a change in the capital structure. It revolves around the concept used to evaluate the amount of debt that a company is required to repay.

The degree of financial leverage formula helps derive the sensitivity of the earnings per share (EPS) with respect to the changing operating income caused by the change in the capital structure of a firm. The degree tells the firm how likely it is for it to be burdened with financial liabilities. In short, it helps quantify the financial risk a business is exposed to.

When the degree of financial leverage formula results in a higher degree, it reflects the higher volatility of the earnings per share. This degree lets companies know the amount of debt or financial obligations that their capital structure allows it to bear. Based on this degree, therefore, the firms can decide the extent to which it should take financial risk.

The interest that a company has to pay on its debt or financial liabilities is a fixed expense. Hence, the changes in the figures are reflective of the EPS and returns. When the operating income is on the higher side, the returns and earnings per share of a firm are good, while if the operating income reflects a tight figure, it is indicative of tough economic times.

When it comes to calculating the degree of financial leverage using the formula, there are multiple ways of figuring that out.

• First, the formula is derived by dividing the percentage change in the net income by the percentage change in the earnings before interest and taxes (EBIT), and mathematically, it is represented as,

Formula = % change in Net income / % change in EBIT

• Second, on the other hand, reflects the formula derived by EBIT divided by the earnings before taxes (EBT) of the company, which is mathematically represented as,

Formula = EBIT / EBT

Let us have a look at a series of steps to understand how the calculation can be efficiently done to achieve accurate results:

Let us see some simple to advanced examples to understand them better.

Example #1

Let us take the example of Company XYZ Ltd, which has clocked a net income of $400,000 in the current year vis-à-vis $300,000 in the previous year. In the current year, the interest expense and taxes of the company stood at $59,000 and $100,000 respectively, while in the previous year, they stood at $40,000 and $90,000 respectively. Determine the DFL for Company XYZ Ltd.

Use the following data to calculate the degree of financial leverage formula.

For the calculation of a degree of financial leverage first, we will calculate the following values,

% Change in Net Income

% Change in Net Income = Change in net income / Net income _{previous year} * 100%

= $100,000 / $300,000 * 100%

= 33.33%

EBIT for Current Year

EBIT _{current year} = Net income _{current year} + Interest expense _{current year} + Taxes _{current year}

= $400,000 + $59,000 + $100,000

= $559,000

EBIT for Previous Year

EBIT _{previous year} = Net income _{previous year} + Interest expense _{previous year} + Taxes _{previous year}

= $300,000 + $40,000 + $90,000

= $430,000

% Change in EBIT

% change in EBIT = Change in EBIT / EBIT _{previous year} * 100%

= $129,000 / $430,000 * 100%

= 30.00%

Now, the calculation of the degree of financial leverage formula is as follows,

• DFL Formula = % change in net income / % change in EBIT
• DFL Formula= 33.33% / 30.00%

Degree of Financial Leverage will be -

DFL = 1.11

Therefore, a 1% change in XYZ Ltd’s leverage will change its operating income by 1.11%.

Example #2

Let us take the example of another Company, ABC Ltd, which has a clocked net income of $200,000 as per the last reported annual result. The interest was charged at 5% on an outstanding debt of $1,000,000, and the taxes paid were $25,000. Determine the DFL for Company ABC Ltd.

Use the following data for the calculation of the degree of financial leverage.

Where Interest expense = Interest rate * Outstanding debt

= 5% * $1,000,000

= $50,000

For the calculation of the degree of financial leverage formula first, we will calculate the following values,

EBIT

EBIT = Net income + Interest expense + Taxes paid

= $200,000 + $50,000 + $25,000

= $275,000

EBT

EBT = Net income + Interest expense

= $200,000 + $25,000

= $225,000

Now, the calculation of the degree of financial leverage formula is as follows,

• DFL Formula = EBIT / EBT
• DFL Formula = $275,000 / $225,000

Degree of Financial Leverage will be -

DFL = 1.22

Therefore, a 1% change in ABC Ltd’s leverage will change its operating income by 1.22%.

It is important to understand the concept of the degree of financial leverage because it indicates the relationship between the capital structure of a company and its operating income. A low ratio is indicative of the low percentage of debt in a company's capital structure, which again indicates that the sensitivity of the net income to the fluctuation in operating income is low. As such, these companies are more stable. On the other hand, a high ratio indicates a higher percentage of debt in a company's capital structure. These companies are vulnerable because their net income is more responsive to fluctuations in operating income.