Degree of Financial Leverage (DFL)

Definition of Degree of Financial Leverage

The degree of financial leverage (DFL) is the leverage ratio that sums up the effect of an amount of financial leverage on the earning per share of a company. The degree of financial leverage or DFL makes use of fixed cost to provide finance to the firm and also includes the expenses before interest and taxes. If the Degree of Financial Leverage is high, the Earnings Per Share or EPS would be more unpredictable while all other factors would remain the same.

Formula for calculating Degree of Financial Leverage

The Degree of Financial Leverage (DFL) can be calculated with the following formula:

DFL = % Change in EPS / % Change in EBIT

Where EPS is the Earnings per Share and EBIT is the Earnings before interest and Taxes.

The degree of financial leverage or DFL helps in calculating the comparative change in net income caused by a change in the capital structure of business. This ratio would help in determining the fate of net income of the business. This ratio also helps in determining the suitable financial leverage which is to be used to achieve the business goal. The higher the leverage of the company, the more risk it has, and a business should try and balance it as leverage is similar to having a debt.

This formula can be even used to compare data of many companies that can help an investor in deciding which company to invest in, based on the result of how much risk is attached with each companies capital structures. It would help an investor to strike a great deal as when the there is an economic decline the losses of the company can be substantiated with this investment and during the rise in the economic conditions the volume of sales would be well compensated.

The degree of financial leverage is useful for figuring out the fate of net income in the future, which is based on the changes that take place in the interest rates, taxes, operating expenses and other financial factors. Debts added to a business would provide an interest expense to the company which is a fixed cost, and this is when the company’s business begins to turn to provide profit. It is important to balance the financial leverage according to the operating costs of the company as it would minimize the level of risks involved.