Degree of Financial Leverage (DFL)

Another measure of financial leverage is the Degree of Financial Leverage (DFL). The degree of financial leverage is the factor by which net income can be expected to change in the future in relation to a future  change in earnings before interest and taxes, since interest on debt is a fixed expense.

The degree of financial leverage is meaningful at only one level of income and interest expense. When those levels change, the degree of financial leverage will change as well.

The degree of financial leverage at a given level of net income is:

or

The formula above results in the DFL for the earlier of the two periods. The above formula can be used when two periods of financial information are available or when the later period consists of projected financial information.

When only one period of financial information is available, the DFL for that period can be calculated using:

or

The DFL predicts the effect on the future EBT of a given future percentage increase in EBIT.

For the two methods of calculating DFL to result in the same DFL, the following assumptions are required:

• Variable costs represent the same percentage of revenue in both periods, so the contribution margin ratio (contribution margin divided by revenue) is the same for both periods.
• Total fixed costs are the same for both periods.
• Non-operating gains or losses (and discontinued operations, if applicable), interest income, and interest expense are the same in both periods.
• The tax rate is the same for both periods.
• EBIT ÷ EBT is used to calculate DFL for the earlier period only.

If assumptions regarding the result of the degree of financial leverage are being applied to net income after
tax as well, it must also be assumed that the income tax rate will remain the same.

For the purposes of calculating degree of financial leverage, EBIT, EBT and net income are calculated as follows:

When financial leverage is used, a given percentage increase in EBIT will result in an even greater percentage increase in EBT, because interest expense (the difference between EBIT and EBT) is a fixed expense. Once interest expense has been covered by EBIT, further increases in EBIT flow straight to EBT. However, the opposite is also true: a given percentage decrease in EBIT will result in an even greater percentage decrease in EBT.

The degree of financial leverage measures both the opportunity and the risk inherent in debt from the standpoint of the shareholder. The higher the degree of financial leverage, the higher the multiplication factor, whether positive (opportunity) or negative (risk of loss).

The degree of financial leverage is the ratio by which earnings before taxes (EBT) will change in response to a change in earnings before interest and taxes (EBIT), assuming that the contribution margin ratio and all other income statement items, including interest expense, remain the same. If assumptions regarding the result of the degree of financial leverage are being applied to net income after tax as well, it must also be assumed that the tax rate will remain the same.

Degree of financial leverage is not a static measurement. A firm’s degree of financial leverage varies with its EBIT. As EBIT increases, DFL decreases because the proportional increase in EBT is greater than the proportional increase in EBIT.