Degree of Financial Leverage

Degree of financial leverage is a measure that assesses how sensitive a company’s net income is to a change in the company’s operating income. It is calculated by dividing percentage change in earnings per share by percentage change in earnings before interest and taxes (EBIT).

If a company has high debt and preferred stock and hence high fixed financing costs such as interest and preferred dividends, a change in its earnings before interest and taxes (EBIT) will result in a more pronounced increase in the company’s net income. This is because interest expense and preferred dividends are fixed no matter the level of EBIT. If EBIT increases, interest and preferred dividends do no increase proportionately and hence net income increases by a different percentage.

A high degree of financial leverage indicates high risk.

Formula

Degree of financial average is defined as the percentage change in earnings per share divided by percentage change in EBIT. This can be written as follows:

$$ Degree\ of\ Financial\ Leverage\\=\frac{Percentage\ Change\ in\ EPS}{Percentage\ Change\ in\ EBIT} $$

$$ Degree\ of\ Financial\ Leverage\\=\frac{New\ EPS−Old\ EPS}{Old\ EPS}÷\frac{New\ EBIT\ -\ Old\ EBIT}{Old\ EBIT} $$

After some mathematical manipulation, we can find the following formula for degree of financial leverage:

$$ Degree\ of\ Financial\ Leverage=\frac{EBIT}{EBIT−Interest\ Expense} $$

Written by Obaidullah Jan