What is Degree Of Financial Leverage?

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A degree of financial leverage (DFL) is a leverage ratio that measures the sensitivity of a company’s earnings per share (EPS) to fluctuations in its operating income, as a result of changes in its capital structure. The degree of financial leverage (DFL) measures the percentage change in EPS for a unit change in operating income, also known as earnings before interest and taxes (EBIT).This ratio indicates that the higher the degree of financial leverage, the more volatile earnings will be. Since interest is usually a fixed expense, leverage magnifies returns and EPS. This is good when operating income is rising, but it can be a problem when operating income is under pressure.

Definition

Financial leverage refers to the leverage ratio that measures the sensitivity of a company's earnings per share (EPS) to fluctuations in its operating income. This ratio indicates the degree of change in EPS due to changes in the capital structure. Higher financial leverage implies greater volatility in earnings.

Origin

The concept of financial leverage originated from studies on corporate capital structure, particularly in the mid-20th century, as scholars began to focus on how different financing methods affect a company's profitability.

Categories and Features

Financial leverage can be categorized into high leverage and low leverage. High leverage companies typically rely more on debt financing, which can lead to higher returns during economic booms but also increases risk during downturns. Low leverage companies are more conservative, with less risk but also limited growth in returns.

Case Studies

A typical case is Lehman Brothers during the 2008 financial crisis. Due to its high leverage, a decline in operating income led to significant EPS volatility, ultimately resulting in bankruptcy. Another example is Apple Inc., whose lower leverage allowed it to maintain relatively stable profitability amid market fluctuations.

Common Issues

Investors often misunderstand that high leverage is always beneficial, whereas, in reality, high leverage can lead to severe financial distress during economic downturns. Additionally, excessive reliance on debt financing may limit a company's financial flexibility.

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