Financial Leverage Ratio

Degree of financial leverage ratio (DFL) measures the extent to which a firm relies on debt. Recall that debt and equity are the two ways for financing a firm. A firm with debt, which is the usual situation, is termed a financially leveraged firm.

Financial leverage is akin to operating leverage. However, whereas operating leverage is sensitive to the amount of a firm’s fixed costs of operation, financial leverage is sensitive to the amount of a firm’s fixed costs of financing. Interest payments on debt must be paid regardless of sales level. Therefore, in

a manner similar to that for operating leverage, a firm with high financial leverage is in a favorable position to profit from an expanding economy, when sales are growing, and is in an unfavorable or dangerous position in a contracting economy.

The degree of financial leverage (DFL) is the ratio of the percentage change in earnings per share (EPS) to the percentage change in earnings before interest and taxes (EBIT). It can be defined by the following equation, which gives three equivalent forms of the right side:

% ∆ EBIT ∆ EBIT

EPS ∆ EBIT

EBIT

A more direct way for calculating the operating leverage is

( 1 − Tax Rate )

where EBT is earnings before taxes and PD is the preferred dividends paid to holders of preferred stock. Whenever the percentage change in EPS is greater than the percentage change in EBIT, DFL is greater than one and the firm is said to be financially leveraged. Note that preferred stock is treated as part of a firm’s debt in calculating financial leverage. (Although in one sense preferred stock is part of a firm’s equity that is, the owners’ investment in the firm. In another sense preferred stock is part of a firm’s debt, because dividends on preferred stock are fixed and must be paid before dividends to holders of common stock). Investors who hold preferred stock are guaranteed to receive their dividends before holders of common stock. Payments to preferred stockholders therefore reduce the earnings per share (EPS) available to common stockholders. Because preferred dividends are paid with after-tax dollars, the second term of the denominator of equation 10.11 is needed to reduce the EBT  the earnings before taxesby the before-tax dollars needed to pay preferred dividends.

Substituting values from the income statement for the ABC Company into equation 10.11 gives

DFL =

340 ® ❧ Corporate Financial Analysis with Microsoft Excel

Degree of Combined or Total Leverage Most firms use both operating and financial leverage in establishing their capital structure. The combined

effect of the two is given by the degree of combined or total leverage (DCL), which is defined as the product of the first two; that is,

% ∆ EBIT % ∆ EPS % ∆ EPS

DCL = DOL DFL × =

% ∆ Sales % ∆ EBIT % % ∆Sales

Equation 10.12 can also be written in the following form:

where I equals the amount of interest, T is the tax rate, and the other symbols are as defined previously. The combined leverage for the ABC Company is calculated as follows from the values of OLR and FLR calculated earlier:

DCL = . 1 85 1 40 2 59 × . = .

Financial Leverage Ratio