Degree of Financial Leverage – DFL Definition
Contents
Unlocking the Complexity of Degree of Financial Leverage (DFL)
Understanding Degree of Financial Leverage
The Degree of Financial Leverage (DFL) serves as a crucial leverage ratio, offering insights into how a company's earnings per share (EPS) respond to fluctuations in operating income due to shifts in its capital structure. Essentially, DFL quantifies the percentage change in EPS for a unit change in operating income, also known as earnings before interest and taxes (EBIT).
Deciphering the DFL Formula
DFL can be computed using the formula: DFL = % change in EPS / % change in EBIT. Alternatively, it can be expressed as DFL = EBIT / (EBIT - Interest). This ratio highlights the impact of changes in operating income on EPS, with higher DFL indicating greater EPS volatility.
Insights from Degree of Financial Leverage
A higher DFL implies heightened EPS volatility, which can be beneficial during periods of rising operating income but problematic amidst economic downturns. Companies utilize DFL to gauge their optimal debt levels within their capital structures, considering the stability of their operating income. Industries such as retail, airlines, and banking often operate with high DFL, but excessive leverage can lead to bankruptcy, as evidenced by historical examples.
Illustrating DFL with Examples
Let's delve into an example to understand DFL better. Suppose hypothetical company BigBox Inc. reports an EBIT of $100 million in Year 1, with $10 million interest expense and 100 million shares outstanding. Computing DFL reveals how EPS responds to changes in EBIT. For instance, a 20% increase in operating income results in a 22.2% rise in EPS, demonstrating the impact of DFL.