Degree of Financial Leverage Formula (Table of Contents)
- Degree of Financial Leverage Formula
- Examples of Degree of Financial Leverage Formula (With Excel Template)
- Degree of Financial Leverage Formula Calculator
Degree of Financial Leverage Formula
Financial leverage, as its name suggests, is the leverage which a company is getting by using debt in its capital structure. An increase of debt in capital structure will increase the financial risk because of the reason that debt comes with interest payments which the company has to pay irrespective of the fact they are making money or not. Degree of financial leverage is one the important parameter which measures the sensitivity of earnings per share (EPS) with the change in Operating profit (EBIT). This ratio plays a very vital role to determine the financial risk associated with the company’s operations.
A high degree of financial leverage signifies that even a small change in leverage can make significant on the company’s profitability and a low degree of financial leverage indicates lower financial risk. The reason behind this is really simple; higher leverage increases the interest payments, which is basically a fixed cost. So if the returns are good, this fixed cost will be spread across, which is good for business, but if a business is not going well, this fixed cost will become troublesome for the company.
There is no single formula to calculate the degree of financial leverage, and different methods are used based on the purpose of analysis. Two of the methods to calculate the degree of financial leverage is given by:
- EBIT – Earnings before Interest and Tax also called Operating Profit
- EPS – Earnings per Share
Examples of Degree of Financial Leverage Formula (With Excel Template)
Let’s take an example to understand the calculation of Degree of Financial Leverage in a better manner.
Degree of Financial Leverage Formula – Example #1
Let say company X has an operating income (EBIT) of $50 million and interest expense for that year is $8 million. This is a listed firm on a stock exchange with 20 million shares outstanding. Let’s ignore the tax effect for now.
Net Earning is calculated using the formula given below
Net Earning = EBIT – Interest Expenses
- Net Earning = $50 -$8
- Net Earning = $42
Earning Per Share is calculated using the Formula given below
Earning Per Share = Net Earning / Number of Shares
- Earning Per Share = $42 / 20
- Earning Per Share = $2.10 per share
The degree of financial leverage is calculated using the Formula given below
Degree of Financial Leverage = EBIT / (EBIT – Interest)
- Degree of Financial Leverage = $50 / ($50 – $8)
- Degree of Financial Leverage = 1.19
It means that a 1% change in EBIT will change EPS by 1.19%
So if for next year, let’s say EBIT change by 10%,
So
- New EBIT = 50 * 1.1
- New EBIT = $55 million
New Earning Per Share is calculated using the Formula given below
Earning Per Share = Net Earning / Number of Shares
- Earning Per Share = ($55 – $8) / 20
- Earning Per Share= $2.35 per share
Earning Per Share with a Degree of Leverage is calculated using the Formula given below.
Earning Per Share with Degree of Leverage = Earning Per Share *(1 + Degree of Financial Leverage /10)
- Earning Per Share with Degree of Leverage = $2.10 * (1 + 1.19 / 10)
- Earning Per Share with Degree of Leverage = $2.35 per share
Degree of Financial Leverage Formula – Example #2
Now let’s take 2 companies with the same operating earnings but a different level of leverage and see their degree of financial leverage. Company A and B have EBIT of $10 million, but company A has very less debt in its capital structure, so its interest payment is $0.5 million. But company B has higher debt and interest, say $2 million.
The degree of Financial Leverage for A is calculated using the formula given below.
Degree of Financial Leverage = EBIT / (EBIT – Interest )
- Degree of financial leverage for A = $10 / ($10 – $0.5)
- Degree of financial leverage for A = $1.05
The degree of Financial Leverage for B is calculated using the formula given below.
Degree of Financial Leverage = EBIT / (EBIT – Interest )
- Degree of financial leverage for B = $10 / ($10 – $2)
- Degree of financial leverage for B = $1.25
It means that Company B is more sensitive towards change in EBIT than company A. 1% change in EBIT will change B’s earnings per share by 1.25%, whereas the same change in EBIT will only result in a 1.05% change in A’s earnings per share.
Explanation of Degree of Financial Leverage Formula
Companies use leverage in their capital structure to increase their return on equity. But leverage, As discussed above, is a very dangerous concept, and if a company is not certain about its earnings and profitability, that can be a very tricky road to walk on. Leverage can multiply the effect on return but can also put a company in a state of bankruptcy. That is the reason companies should keep a close eye on their leverage and its effect on profitability and degree of financial leverage helps them in achieving that.
Degree of financial leverage few important parameters of any business financials, i.e. operating income, earning per share and debt payments (interest expenses). Companies which have higher EPS are considered to be favorable investments as compared to companies with lower EPS. The reason behind this is that higher EPS generally results in higher income for investors. Similarly, any business which has good operating profits are good investments since they are making efficient use of their resources. But debt obligations have the capacity to change the whole equation. Companies having good EPS and EBIT in one period can be in distress if their performance is not good and debt obligations are high.
Relevance and Uses
The degree of financial leverage, in a way, helps companies to determine the amount of debt which they can comfortable able to manage in their capital structure. The more stable the operating income is, the more stable the will be EPS, and therefore a company can incorporate more debt in its structure. If the operating income is not stable, the company will not have an appetite to include debt since that will further increase the financial risk. But anyone who is using this ratio has to keep in mind that this ratio is not the same for all the companies and vary from industry to industry. Companies operating in the area of banking, manufacturing, and retail industry will generally have a higher degree of financial leverage.
Generally, a higher degree of financial leverage indicates higher risk, and that is the reason that many companies operating with a higher degree of financial leverage opt for bankruptcy. The simple reason for that is they were not making enough profits to cater to their financial obligations.
Degree of Financial Leverage Formula Calculator
You can use the following Degree of Financial Leverage Calculator
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