What it means
Interest is a fixed cost that sits between operating profit and the profit available to shareholders. When operating profit rises, interest does not, so the increase flows entirely to shareholders and their earnings rise by a larger percentage than operating profit did.
When operating profit falls, interest still does not, and shareholders' earnings fall by a larger percentage. The degree of financial leverage is the multiplier: the ratio of the percentage change in earnings per share to the percentage change in operating profit that caused it.
With no debt the multiplier is 1.0, since earnings move exactly with operating profit; every dollar of interest raises it. The formula follows directly.
If operating profit is E and interest is I, profit before tax is E minus I, and a small change in E changes profit before tax by the same amount; the percentage change in profit before tax is therefore the change divided by (E minus I), while the percentage change in operating profit is the change divided by E. The ratio of the two is E divided by (E minus I).
Tax does not affect the ratio, since it applies proportionately to profit before tax, but preference dividends do: they are paid after tax, so their pre-tax equivalent (the dividend divided by one minus the tax rate) is deducted alongside interest. The measure is a point estimate at a given level of operating profit, and it is not constant.
As operating profit rises well above the interest bill, the ratio falls towards 1.0 and the amplifying effect fades; as operating profit falls towards the interest bill, the ratio rises without limit, and at the point where operating profit equals interest, earnings are zero and any further fall produces a loss. This behaviour is the essential point about financial leverage: it is comfortable when profits are high and dangerous when they are low, and the danger arrives exactly when the company can least afford it.
Financial leverage is a choice. A board that finances the business with more debt raises the degree of financial leverage and, if operating profit is stable and above the interest bill, raises the return on equity and earnings per share.
The cost is volatility and, in the extreme, the risk that a fall in operating profit leaves the company unable to pay its interest. The appropriate degree depends on the stability of operating profit, which is itself the product of the business's operating leverage and the volatility of its sales: a company with volatile operating profit should run low financial leverage, and one with stable operating profit can run higher.
The degree of combined leverage captures the two together. The measure is used in three ways.
In capital structure decisions, a board compares the degree of financial leverage under alternative financing plans and asks what it would mean for earnings in a bad year. In analysis, an investor uses it to understand why a company's earnings are more or less volatile than its operating profit and to compare the financial risk of companies in the same industry.
And in forecasting, it converts a range of operating profit outcomes into a range of earnings outcomes, which is often the range the board and the market actually care about.
In practice
Real-world examples.
Example
A utility with operating profit of $500,000,000 and interest of $200,000,000 has a DFL of 1.67, which is acceptable because its operating profit varies by only a few percent a year.
Example
A retailer with a DFL of 1.2 borrows to buy back shares and raises it to 2.0; in the next downturn, a 30% fall in operating profit becomes a 60% fall in earnings per share.
Example
A company with no debt has a DFL of 1.0, and its board debates whether modest borrowing would raise the return on equity by more than it raised the risk.
Think of it
“Financial leverage amplifies your earnings changes-good news gets better, but bad news gets worse.
Formula
Calculation
Degree of financial leverage (DFL) = Operating profit / (Operating profit minus Interest)
With preference dividends: DFL = Operating profit / (Operating profit minus Interest minus Preference dividends / (1 minus Tax rate))
Also: DFL = Percentage change in earnings per share / Percentage change in operating profit
Worked example. A company has operating profit of $1,500,000 and interest of $500,000.
- DFL = $1,500,000 / ($1,500,000 minus $500,000) = 1.5
- If operating profit rises 20% to $1,800,000: profit before tax = $1,300,000, a rise of 30% on $1,000,000, as DFL of 1.5 predicts
- If operating profit falls 30% to $1,050,000: profit before tax = $550,000, a fall of 45%
Alternative structure. If the company had borrowed more and its interest were $900,000:
- DFL = $1,500,000 / $600,000 = 2.5
- The same 30% fall in operating profit to $1,050,000 would leave profit before tax of $150,000, a fall of 75%
- A 40% fall in operating profit, to $900,000, would leave nothing; under the original structure it would leave $400,000
With preference shares. If the company also pays preference dividends of $150,000 and its tax rate is 25%, the pre-tax equivalent is $150,000 / 0.75 = $200,000.
- DFL = $1,500,000 / ($1,500,000 minus $500,000 minus $200,000) = $1,500,000 / $800,000 = 1.875
Point sensitivity. The DFL under the original structure at different levels of operating profit: at $3,000,000 it is 1.2; at $1,500,000 it is 1.5; at $750,000 it is 3.0; at $550,000 it is 11.0. The leverage bites hardest when profit is weakest.Case study
Seen in the real world.
Two industrial distributors with identical operations and operating profit of $5,000,000 differed only in their financing. Company N had no debt; Company L had borrowed $30,000,000 at 6%, paying $1,800,000 of interest, and had used the money to buy back shares, so that it had 60% as many shares as Company N. Company L's degree of financial leverage was $5,000,000 / $3,200,000 = 1.56; Company N's was 1.0.
In an ordinary year, Company L's earnings per share were about 7% higher than Company N's, because its profit after interest and tax, $2,400,000, was spread over fewer shares than Company N's $3,750,000 (both at a 25% tax rate), and its return on equity was correspondingly higher. Company L's shares were rated more highly and its chief executive was praised for capital efficiency.
A recession cut both companies' operating profit by 50%, to $2,500,000. Company N's earnings fell by 50%, from $3,750,000 to $1,875,000 after tax. Company L's profit after interest fell from $3,200,000 to $700,000, a fall of 78%, and after tax to $525,000.
Its DFL at the new level of operating profit had risen to $2,500,000 / $700,000 = 3.6, so that any further fall in operating profit would have hit earnings more than three times as hard. Its lenders' interest cover covenant of 2.0 times was breached (cover 1.39 times), its dividend was suspended, and its shares fell by 70% against 35% for Company N. Company N, meanwhile, used its unlevered balance sheet to buy two smaller competitors at distressed prices.
Over the full cycle Company N's shareholders did better, despite the lower earnings per share in the good years. An analyst's review put the point in terms of the DFL: Company L's leverage of 1.56 had looked modest at $5,000,000 of operating profit, but the measure is a point estimate, and at $2,500,000 it was 3.6.
The company had chosen a financial structure on the basis of a good year and had been surprised that the structure behaved differently in a bad one. The analyst's rule of thumb was to calculate the DFL not at expected operating profit but at the lowest operating profit the business had experienced in the last two cycles, and to ask whether the resulting earnings were survivable.
Watch out
Common mistakes.
- Calculating the DFL at expected operating profit and treating it as fixed, when it rises sharply as operating profit falls and is highest exactly when the company is weakest.
- Forgetting preference dividends, which are as fixed as interest and must be grossed up for tax in the calculation.
- Judging financial leverage without reference to operating leverage; a company with volatile operating profit should carry less debt than one with stable operating profit, whatever the DFL at current profit.
Questions
People also ask.
What is the difference between the degree of financial leverage and the debt-to-equity ratio?
The debt-to-equity ratio is a balance sheet measure of how much debt the company carries relative to equity; the degree of financial leverage is an income statement measure of how much that debt's interest amplifies changes in earnings. Two companies with the same debt-to-equity ratio can have very different DFLs if their operating profits differ.
What does a DFL of 1.0 mean?
That the company has no fixed financing costs, so earnings move exactly in proportion to operating profit. Any interest or preference dividend raises it above 1.0.
How does financial leverage affect the cost of equity?
It raises it. Shareholders in a leveraged company bear more volatile earnings and a higher risk of loss, and they require a higher return to compensate, which is why the benefit of cheap debt is partly offset by a dearer cost of equity as leverage rises.
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