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 per share (EPS) to fluctuations in its operating income, as a result 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, also known as earnings before interest and taxes (EBIT).

This ratio indicates that the higher the degree of financial leverage, the more volatile earnings will be. Since interest is usually a fixed expense, leverage magnifies returns and EPS. This is good when operating income is rising, but it can be a problem when operating income is under pressure.

The Formula for DFL Is

DFL = % change in EPS % change in EBIT \text{DFL}=\frac{\%\text{change in EPS}}{\%\text{change in EBIT}} DFL=%change in EBIT%change in EPS

DFL can also be represented by the equation below:

DFL = EBIT EBIT  −  Interest \text{DFL}=\frac{\text{EBIT}}{\text{EBIT }-\text{ Interest}} DFL=EBIT − InterestEBIT

What Does Degree of Financial Leverage Tell You?

The higher the DFL, the more volatile earnings per share (EPS) will be. Since interest is a fixed expense, leverage magnifies returns and EPS, which is good when operating income is rising but can be a problem during tough economic times when operating income is under pressure.

DFL is invaluable in helping a company assess the amount of debt or financial leverage it should opt for in its capital structure. If operating income is relatively stable, then earnings and EPS would be stable as well, and the company can afford to take on a significant amount of debt. However, if the company operates in a sector where operating income is quite volatile, it may be prudent to limit debt to easily manageable levels.

The use of financial leverage varies greatly by industry and by the business sector. There are many industry sectors in which companies operate with a high degree of financial leverage. Retail stores, airlines, grocery stores, utility companies, and banking institutions are classic examples. Unfortunately, the excessive use of financial leverage by many companies in these sectors has played a paramount role in forcing a lot of them to file for Chapter 11 bankruptcy.

Examples include R.H. Macy (1992), Trans World Airlines (2001), Great Atlantic & Pacific Tea Co (A&P) (2010) and Midwest Generation (2012). Moreover, excessive use of financial leverage was the primary culprit that led to the U.S. financial crisis between 2007 and 2009. The demise of Lehman Brothers (2008) and a host of other highly levered financial institutions are prime examples of the negative ramifications that are associated with the use of highly levered capital structures.

Example of How to Use DFL

Consider the following example to illustrate the concept. Assume hypothetical 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. (For the sake of clarity, let’s ignore the effect of taxes for the moment.)

EPS for BigBox in Year 1 would thus be:

Operating Income of $100 Million  −  $10 Million Interest Expense 100 Million Shares Outstanding = $ 0 . 9 0 \frac{\text{Operating Income of \$100 Million }-\text{ \$10 Million Interest Expense}}{\text{100 Million Shares Outstanding}}=\$0.90 100 Million Shares OutstandingOperating Income of $100 Million − $10 Million Interest Expense=$0.90

The degree of financial leverage (DFL) is:

$100 Million $100 Million  −  $10 Million = 1 . 1 1 \frac{\text{\$100 Million}}{\text{\$100 Million }-\text{ \$10 Million}}=1.11 $100 Million − $10 Million$100 Million=1.11

This means that for every 1% change in EBIT or operating income, EPS would change by 1.11%.

Now assume that BigBox has a 20% increase in operating income in Year 2. Notably, interest expenses remain unchanged at $10 million in Year 2 as well. EPS for BigBox in Year 2 would thus be:

Operating Income of $120 Million  −  $10 Million Interest Expense 100 Million Shares Outstanding = $ 1 . 1 0 \frac{\text{Operating Income of \$120 Million }-\text{ \$10 Million Interest Expense}}{\text{100 Million Shares Outstanding}}=\$1.10 100 Million Shares OutstandingOperating Income of $120 Million − $10 Million Interest Expense=$1.10

In this instance, EPS has increased from 90 cents in Year 1 to $1.10 in Year 2, which represents a change of 22.2%.

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

If EBIT had decreased instead to $70 million in Year 2, what would have been the impact on EPS? EPS would have declined by 33.3% (i.e., DFL of 1.11 x -30% change in EBIT). This can be easily verified since EPS, in this case, would have been 60 cents, which represents a 33.3% decline.