How to Calculate the Degree of Financial Leverage?

Imagine your business suddenly sees a massive increase in revenue. Would your profits soar as well, or would the additional earnings get absorbed by costs? This is where the Degree of Financial Leverage (DFL) comes into play. It is a crucial metric for businesses to understand how effectively they are leveraging borrowed funds and fixed financial costs to increase profits. The DFL ratio provides a detailed insight into how changes in the company’s operating income affect its net income due to financial leverage.

Before diving into the actual formula and process of calculating the Degree of Financial Leverage, let’s first establish a clear understanding of what financial leverage is and why it's important.

What is Financial Leverage?

Financial leverage refers to the use of debt financing in the capital structure of a company. In simpler terms, it's the practice of borrowing money to fund operations, expansion, or other investments, with the hope that the returns generated will be greater than the cost of borrowing. The more debt a company uses relative to equity, the higher its financial leverage.

While using leverage can significantly amplify a company's profits during good times, it can also increase financial risk during downturns. That's why businesses must evaluate their degree of financial leverage (DFL) carefully.

The degree of financial leverage is important for companies that rely heavily on debt to finance operations or growth. A company with high financial leverage can generate more returns for shareholders but is also more exposed to risks if the company’s revenue drops. Conversely, a company with low financial leverage has less risk but may not experience as significant growth in profits.

Why Should Businesses Calculate Their DFL?

The Degree of Financial Leverage is a valuable tool for financial managers, investors, and analysts for the following reasons:

1. Risk Management: Understanding DFL helps businesses assess the financial risk associated with their debt.
2. Profitability Analysis: It helps gauge how a company's profitability will change with varying levels of operating income.
3. Capital Structure Decisions: Helps management decide the optimal mix of debt and equity.

The DFL Formula

The Degree of Financial Leverage is calculated by using the following formula:

$DFL=\frac{\%ChangeinNetIncome}{\%ChangeinOperatingIncome}$DFL=% Change in Operating Income% Change in Net Income​

Alternatively, you can use this formula when the operating income (EBIT) and interest expenses are known:

$DFL=\frac{EBIT}{EBIT-InterestExpense}$DFL=EBIT−Interest ExpenseEBIT​

Step-by-Step Calculation of DFL

To make this calculation more concrete, let’s go through a practical example.

Example:

Let’s assume a company has the following details:

• Operating Income (EBIT): $500,000
• Interest Expense: $100,000

Now, let’s calculate the Degree of Financial Leverage (DFL):

1. First, we apply the formula: $DFL=\frac{EBIT}{EBIT-InterestExpense}$DFL=EBIT−Interest ExpenseEBIT​
2. Substituting the values: $DFL=\frac{500,000}{500,000-100,000}=\frac{500,000}{400,000}=1.25$DFL=500,000−100,000500,000​=400,000500,000​=1.25

Interpretation: The Degree of Financial Leverage for this company is 1.25. This means that for every 1% increase in operating income, the company’s net income will increase by 1.25%. However, the same holds true for a decrease in operating income: for every 1% drop in EBIT, the net income will decrease by 1.25%.

A Closer Look at the Components of the Formula

Operating Income (EBIT)

The Operating Income is also known as Earnings Before Interest and Taxes (EBIT). It represents the profit a company makes from its core operations before subtracting any interest or tax expenses. In the DFL formula, this value serves as the base measure to determine how much the company is earning from its normal operations before financial obligations.

Interest Expense

The Interest Expense represents the cost a company incurs from borrowing money, such as loans or bonds. The higher the interest expense, the more debt the company has taken on. In the DFL formula, this expense is deducted from EBIT to reflect the company's net operating income after covering its debt obligations.

How Leverage Impacts Profitability

To understand why calculating DFL is so important, let’s compare the performance of two hypothetical companies: one with high financial leverage and one with low leverage.

Company	Operating Income (EBIT)	Interest Expense	DFL
Company A	$1,000,000	$200,000	1.25
Company B	$1,000,000	$50,000	1.05

Both companies have the same EBIT, but Company A has much higher interest expenses. As a result, it has a higher DFL, meaning its net income will fluctuate more significantly with changes in operating income compared to Company B.

If both companies see their operating income increase by 10%, Company A's net income will increase by 12.5%, while Company B's will increase by only 10.5%. On the flip side, if EBIT decreases, Company A's net income will decline more sharply than Company B’s, showcasing the higher risk associated with financial leverage.

Factors that Affect the Degree of Financial Leverage

There are several factors that can influence the DFL of a company:

1. Capital Structure: Companies with more debt will have higher interest expenses, leading to a higher DFL.
2. Revenue Stability: Businesses with stable, predictable revenues can afford higher leverage, as their income is less likely to fluctuate.
3. Interest Rates: As interest rates rise, the cost of borrowing increases, which raises the DFL.
4. Market Conditions: Economic downturns or market volatility can make leveraged companies more vulnerable to financial distress.

The Risks of High Financial Leverage

While financial leverage can boost profits, it also amplifies risks. Some potential dangers of high leverage include:

• Bankruptcy Risk: If a company cannot meet its debt obligations, it may face financial distress or bankruptcy.
• Earnings Volatility: Higher DFL means greater fluctuations in net income, making it harder to predict profitability.
• Reduced Flexibility: Companies with significant debt obligations may have less financial flexibility to invest in new opportunities or weather economic downturns.

Managing Financial Leverage

To strike the right balance between risk and reward, businesses can take several steps to manage their financial leverage effectively:

1. Diversify Revenue Streams: By diversifying sources of income, a company can reduce the impact of market downturns on its earnings.
2. Maintain Adequate Cash Reserves: Keeping sufficient cash on hand ensures that a company can meet its debt obligations even during tough times.
3. Monitor Interest Rates: Companies should keep an eye on interest rate trends and consider refinancing debt when rates are low.
4. Use Hedging Strategies: Businesses can hedge against interest rate fluctuations or other risks to stabilize their financial situation.

Conclusion

Understanding and calculating the Degree of Financial Leverage is critical for businesses that rely on debt financing. It provides valuable insights into how changes in operating income affect net income, helping managers make more informed financial decisions. A well-balanced approach to leverage can help companies maximize their profits while managing risk effectively. However, excessive financial leverage can increase earnings volatility and expose businesses to greater financial risk.

By keeping a close eye on factors such as interest rates, capital structure, and market conditions, companies can optimize their use of leverage to achieve sustainable growth.