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Degree of Financial Leverage - DFL

Degree of Financial Leverage – DFL

What Is a Degree of Financial Leverage - DFL?

A degree of financial leverage (DFL) is a leverage ratio that measures the sensitivity of a company's earnings for every share (EPS) to variances in its operating income, because of changes in its capital structure. The degree of financial leverage (DFL) measures the percentage change in EPS for a unit change in operating income, otherwise called earnings before interest and taxes (EBIT).

This ratio shows that the higher the degree of financial leverage, the more unpredictable earnings will be. Since interest is generally a fixed expense, leverage amplifies returns and EPS. This is great while operating income is rising, yet it tends to be a problem while operating income is feeling the squeeze.

The Formula for DFL Is

DFL=%change in EPS%change in EBIT\text=\frac{%\text}{%\text}
DFL can likewise be addressed by the equation below:
DFL=EBITEBIT  Interest\text=\frac{\text}{\text-\text}

What Does Degree of Financial Leverage Tell You?

The higher the DFL, the more unstable earnings per share (EPS) will be. Since interest is a fixed expense, leverage amplifies returns and EPS, which is great when operating income is rising however can be a problem during intense economic times while operating income is feeling the squeeze.

DFL is significant in assisting a company with evaluating the amount of debt or financial leverage it ought to opt for in its capital structure. On the off chance that operating income is moderately stable, earnings and EPS would be stable too, and the company can stand to take on a lot of debt. Nonetheless, on the off chance that the company operates in a sector where operating income is very unpredictable, restricting debt to effectively sensible levels might be prudent.

The utilization of financial leverage differs greatly by industry and by the business sector. There are numerous industry sectors wherein companies operate with a serious level of financial leverage. Retail stores, carriers, supermarkets, utility companies, and banking institutions are classic models. Sadly, the extreme utilization of financial leverage by many companies in these sectors plays had a paramount impact in compelling a great deal of them to file for Chapter 11 bankruptcy.

Models incorporate R.H. Macy (1992), Trans World Airlines (2001), Great Atlantic and Pacific Tea Co (A&P) (2010) and Midwest Generation (2012). In addition, unreasonable utilization of financial leverage was the primary guilty party that prompted the U.S. financial crisis somewhere in the range of 2007 and 2009. The downfall of Lehman Brothers (2008) and a large group of other profoundly levered financial institutions are prime instances of the negative implications that are associated with the utilization of exceptionally levered capital structures.

Illustration of How to Use DFL

Consider the accompanying guide to represent the concept. Accept theoretical company BigBox Inc. 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.

EPS for BigBox in Year 1 would along these lines be:
Operating Income of $100 Million  $10 Million Interest Expense100 Million Shares Outstanding=$0.90\frac{\text{Operating Income of $100 Million }-\text{ $10 Million Interest Expense}}{\text{100 Million Shares Outstanding}}=$0.90
The degree of financial leverage (DFL) is:
$100 Million$100 Million  $10 Million=1.11\frac{\text{$100 Million}}{\text{$100 Million }-\text{ $10 Million}}=1.11
This means that for each 1% change in EBIT or operating income, EPS would change by 1.11%.

Presently expect that BigBox has a 20% increase in operating income in Year 2. Quite, interest expenses stay unchanged at $10 million in Year 2 too. EPS for BigBox in Year 2 would consequently be:
Operating Income of $120 Million  $10 Million Interest Expense100 Million Shares Outstanding=$1.10\frac{\text{Operating Income of $120 Million }-\text{ $10 Million Interest Expense}}{\text{100 Million Shares Outstanding}}=$1.10
In this case, EPS has increased from 90 pennies in Year 1 to $1.10 in Year 2, which addresses a change of 22.2%.

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

Assuming that EBIT had diminished rather to $70 million in Year 2, what might thely affect EPS? EPS would have declined by 33.3% (i.e., DFL of 1.11 x - 30% change in EBIT). This can be effortlessly checked since EPS, in this case, would have been 60 pennies, which addresses a 33.3% decline.

Features

  • The degree of financial leverage (DFL) is a leverage ratio that measures the sensitivity of a company's earnings for every share to variances in its operating income, because of changes in its capital structure.
  • The utilization of financial leverage changes greatly by industry and by the business sector.
  • This ratio shows that the higher the degree of financial leverage, the more unpredictable earnings will be.