What is Degree of Financial Leverage?
Degree of Financial Leverage (DFL) quantifies the sensitivity of a company’s net income (or EPS) to changes in its operating profit (EBIT) as caused by debt financing.
How to Calculate Degree of Financial Leverage (DFL)
Financial leverage refers to the costs of financing — e.g. interest expense — funding a company’s reinvestment needs like working capital and capital expenditures (CapEx).
Companies can finance the purchase of assets using two sources of capital:
- Equity: Equity Issuances, Retained Earnings
- Debt: Debt Issuances (e.g. Corporate Bonds)
Debt financing comes with fixed financial costs (i.e. interest expense) that remain constant regardless of a company’s performance in a given period.
The higher the degree of financial leverage (DFL), the more volatile a company’s net income (or EPS) will be — all else being equal.
Like operating leverage, financial leverage amplifies the potential returns from positive growth, as well as the losses from declining growth.
- Growth in EBIT → Increased Growth in Net Income
- Decline in EBIT → Increased Losses in Net Income
The degree of financial leverage (DFL) is a measure of financial risk, i.e. the potential losses from the presence of leverage in a company’s capital structure.
DFL is used to understand the relationship between two metrics of a company:
Degree of Financial Leverage Formula (DFL)
DFL refers to the sensitivity of a company’s net income — i.e. the cash flows available to equity shareholders — if its operating income were to change.
The formula for the degree of financial leverage compares the % change in net income (or earnings per share, “EPS”) relative to the % change in operating income (EBIT).
Alternatively, DFL can be calculated using earnings per share (EPS) rather than net income.
For example, assuming that a company’s DFL is 2.0x, a 10% increase in EBIT should result in a 20% rise in net income.