What Is the Degree of Financial Leverage?
Let me explain the degree of financial leverage (DFL) to you—it's a leverage ratio that's essential for grasping a company's financial leverage. The DFL shows how sensitive a company’s earnings per share (EPS) is to fluctuations in its operating income, which come from changes in its capital structure. Specifically, it tells you the percentage change in EPS for every unit change in operating income.
You should know that DFL is vital in strategic planning because it can signal higher earnings volatility from greater financial leverage. As someone managing a company, you can use DFL to guide your decisions on debt and capital structure.
Key Takeaways
- A higher degree of financial leverage (DFL) indicates increased volatility in a company's earnings per share (EPS) in response to changes in operating income. This highlights the potential risk and reward of financial leverage.
- Companies use DFL to gauge how much debt they can safely incorporate into their capital structure. This is particularly essential for industries with stable operating incomes, allowing them to leverage more debt.
- The application of financial leverage varies significantly across industries, with sectors like retail, airlines, and utilities often operating with a high DFL. Understanding these industry norms can be crucial for business strategy and investment decisions.
- Excessive financial leverage has historically led to adverse outcomes, such as bankruptcies in major companies like Lehman Brothers during the 2007-2009 financial crisis, emphasizing the need for prudent financial management.
Understanding the Degree of Financial Leverage Formula
You can calculate DFL as the percentage change in EPS divided by the percentage change in EBIT. The formula is DFL = (% change in EPS) / (% change in EBIT).
Alternatively, use this equation: DFL = EBIT / (EBIT - Interest). This gives you a direct way to compute it from your financials.
Insights From the Degree of Financial Leverage
The higher your DFL, the more volatile your earnings per share (EPS) will be. I recommend using DFL to evaluate how much debt or financial leverage you should include in your capital structure. If your operating income is stable, your earnings and EPS will stay stable too, so you can afford more debt. But in sectors with volatile operating income, keep debt at manageable levels.
Financial leverage use differs a lot by industry and business sector. Many companies operate with a high DFL—think retail stores, airlines, grocery stores, utility companies, and banking institutions. Excessive leverage has pushed some in these sectors into Chapter 11 bankruptcy.
Examples include R.H. Macy in 1992, Trans World Airlines in 2001, Great Atlantic & Pacific Tea Co (A&P) in 2010, and Midwest Generation in 2012. Excessive financial leverage was central to the 2007-2009 U.S. financial crisis, with the fall of Lehman Brothers in 2008 and other institutions showing the dangers.
Practical Application of DFL: An Example
Let’s look at a practical example to make this clear. Suppose hypothetical company BigBox Inc. has operating income or EBIT of $100 million in Year 1, interest expense of $10 million, and 100 million shares outstanding. Ignoring taxes for simplicity, EPS in Year 1 is ($100 million - $10 million) / 100 million shares = $0.90.
The DFL is $100 million / ($100 million - $10 million) = 1.11. This means for every 1% change in EBIT, EPS changes by 1.11%.
Now, if BigBox sees a 20% increase in operating income to $120 million in Year 2, with interest still at $10 million, EPS becomes ($120 million - $10 million) / 100 million shares = $1.10. That's a 22.2% increase, which matches 1.11 x 20%.
If EBIT dropped to $70 million instead, a -30% change, EPS would fall to $0.60, a 33.3% decline, confirming 1.11 x -30% = -33.3%.
The Bottom Line
Degree of Financial Leverage (DFL) is a metric that assesses how sensitive your company's EPS is to changes in operating income tied to capital structure. A higher DFL means more volatile earnings. Too much leverage has caused problems like the Lehman Brothers bankruptcy in 2008. Acceptable leverage levels vary by sector, with retail, airlines, and utilities often running high DFL. You need a solid understanding of DFL for strategic financial decisions.
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