Degree of Financial Leverage (DFL)
Unleashing the Potential of Financial Leverage
A degree of financial leverage (DFL) assesses the fluctuation sensitivity of a company’s earnings per share (EPS) concerning its operating income changes due to different capital structures. It quantifies the EPS percentage change against a unit change in operating income (EBIT).
An increased DFL signifies more volatile earnings. With interest as a fixed expense, leverage accentuates returns and EPS, advantageous during revenue growth but risky during economic downturns when operating incomes decline.
Simplifying the DFL Formula
DFL is computed as follows:
Primary Formula
DFL = \\frac{\% change in EPS}{\% change in EBIT}
Secondary Formula
DFL = \\frac{EBIT}{EBIT − Interest}
Distilling Insights from DFL
A higher DFL means a company’s EPS is more sensitive to changes in EBIT, requiring careful debt management for varying operating incomes. Stable operating incomes enable higher debt tolerance due to consistent earnings and EPS. Conversely, volatile sectors should limit debt to manageable levels.
Industry Applications
Financial leverage usage varies across industries like retail, airlines, utilities, and banking. Overleveraging in these sectors has historically led to Chapter 11 bankruptcies and significant impacts during financial crises.
Some notable examples of this include:
- R.H. Macy (1992)
- Trans World Airlines (2001)
- Great Atlantic & Pacific Tea Co (2010)
- Midwest Generation (2012)
High leverage exacerbated risks during the 2007-2009 financial crisis, exemplified by the fall of Lehman Brothers and others.
Key Takeaways
- DFL offers a leverage ratio depicting EPS sensitivity to EBIT changes.
- High DFL implies volatility, benefiting during growth, challenging during downturns.
- Leverage usage and effectiveness vary by industry.
Exemplifying DFL in Action
Illustrate the concept of DFL with a hypothetical example; consider BigBox Inc. with an operating income of $100 million in Year 1, $10 million in interest expenses, and 100 million shares.
Calculating EPS for Year 1
EPS = \\frac{Operating Income of $100 Million − $10 Million Interest Expense}{100 Million Shares} = $0.90
Determining DFL for Year 1
DFL = \\frac{$100 Million}{ $100 Million − $10 Million} = 1.11
Assume a 20% operating income increase in Year 2 but unchanged $10 million interest expenses.
Calculating EPS for Year 2
EPS = \\frac{Operating Income of $120 Million − $10 Million Interest Expense}{100 Million Shares} = $1.10
Consequently, EPS grows from $0.90 to $1.10 (22.2% increase).
Validated by DFL Impact
Computed via: 1.11 * 20% (EBIT Change) = 22.2% (EPS Change).
Contrasting Downturn Scenario
If operating income drops to $70 million:
- EPS falls to 60 cents.
- Representing a 33.3% decline, validated by
DFL of 1.11 * -30% change in EBIT = -33.3%.
Related Terms: Leverage Ratio, Operating Income, Interest Expense, Financial Crisis.
References
- Accounting Tools. “Degree of Financial Leverage Definition”.
