Understand the Degree of Financial Leverage (DFL) and Its Impact on EPS

What Is the Degree of Financial Leverage?

Degree of financial leverage (DFL) is a leverage ratio that’s crucial to the understanding of a company’s financial leverage. The DFL measures the sensitivity of a company’s earnings per share (EPS) to fluctuations in its operating income that result from changes in its capital structure. In particular, the DFL presents the percentage change in EPS for a unit change in operating income.

DFL plays an important role in strategic planning because it can point to greater earnings volatility based on a higher degree of financial leverage. Executive management can use DFL as a guide to managing debt and capital structure.

Understanding the Degree of Financial Leverage Formula

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

You can also calculate DFL using the equation below:

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

Insights From the Degree of Financial Leverage

The higher the DFL, the more volatile earnings per share (EPS) will be. 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 stable, earnings and EPS will also be stable, allowing the company to take on more debt. Conversely, in sectors with volatile operating income, it’s wise to keep debt at manageable levels.

The use of financial leverage varies greatly by industry and by the business sector.  Companies in many industries operate with a high DFL. Retail stores, airlines, grocery stores, utility companies, and banking institutions are classic examples. Excessive use of financial leverage has led some companies in these sectors 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). Excessive financial leverage was a key factor in the 2007-2009 U.S. financial crisis. The fall of Lehman Brothers in 2008 and other leveraged institutions exemplifies the risks of excessive leverage.

Practical Application of DFL: An Example

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:

$\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:

$\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:

$\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.

The Bottom Line

Degree of Financial Leverage (DFL) is a metric that assesses how sensitive a company’s EPS is to changes in its operating income related to capital structure. A higher DFL suggests more volatile earnings. Too much financial leverage has lead to adverse financial outcomes, such as the Lehman Brothers bankruptcy in 2008. Acceptable levels of financial leverage can vary depending on the sector or industry, with the retail, airlines, and utilities sectors often operating with a high DFL. Thus, a thorough understanding of how DFL works is vital to a company’s strategic financial decision-making.