What it means
Financial leverage means using borrowed money to finance a business. Debt comes with fixed interest payments that must be made regardless of how well the business is doing.
When profits rise, shareholders keep the extra after paying the same interest, so their returns increase sharply. The same effect works in reverse.
When profits fall, the interest payments stay the same, so earnings available to shareholders drop by a larger percentage than operating profit. DFL measures this magnification and gives managers and investors a single number to compare.
A DFL of 1 means a company has no fixed financing costs and its earnings per share move in line with operating profit. A DFL of 2 means a 10% rise in operating profit leads to roughly a 20% rise in earnings per share.
A higher figure signals higher risk as well as higher potential reward. Finance teams use DFL when deciding how much debt to take on.
It helps answer questions such as whether a business can survive a downturn, and how sensitive profits are to a change in sales. Lenders also look at it when judging whether a borrower is taking on too much risk.
DFL is related to, but different from, operating leverage, which looks at fixed operating costs. The two can be combined into degree of total leverage to show the full sensitivity of earnings to changes in sales.
DFL is also only valid at a particular level of profit, so the number changes as profit and interest change. If operating profit is lower than interest, the ratio becomes meaningless or negative.
That is a warning sign that the company cannot cover its interest from earnings, and lenders will usually react to it quickly.
In practice
Real-world examples.
Example
A manufacturing firm with EBIT of $1,000,000 and interest of $400,000 calculates a DFL of 1.67. The CFO tells the board that a 10% fall in operating profit would cut pre-tax earnings by about 16.7%.
Example
A software company with no debt has a DFL of 1.0, because all of its operating profit flows through to shareholders. Its finance team considers borrowing $5 million to fund a share buyback, then calculates how the DFL would rise to see how much extra risk shareholders would carry.
Example
A bank reviewing a loan application asks a retailer for its DFL. The retailer's figure of 3.0 suggests earnings are very sensitive to sales, so the bank adds protective conditions to the loan.
Formula
Calculation
DFL = EBIT / (EBIT - Interest expense)
where EBIT is earnings before interest and tax, a measure of operating profit.
Suppose a company has EBIT of $600,000 and interest expense of $200,000. DFL = $600,000 / ($600,000 - $200,000) = $600,000 / $400,000 = 1.5. If EBIT rises by 10% to $660,000, earnings before tax rise from $400,000 to $460,000, which is a 15% increase, confirming that a 10% rise in EBIT produces a 15% rise (10% x 1.5).Case study
Seen in the real world.
Stonebridge Logistics is a fictional freight company used here as an illustrative example. It has EBIT of $900,000 and interest costs of $300,000, which gives a DFL of $900,000 / $600,000 = 1.5.
The owners want to borrow another $2 million to buy trucks, which would add $150,000 in annual interest. The new DFL would be $900,000 / ($900,000 - $450,000) = 2.0, meaning a 10% dip in operating profit would now cut earnings by 20%. The finance director tests a downturn scenario in which EBIT falls to $500,000, leaving just $50,000 after interest.
Deciding that the margin is too thin, the owners borrow only $1 million and negotiate a longer repayment term. The example shows how DFL can turn a gut feeling about risk into a number, and the board agrees to review the figure every time it considers new borrowing.
Watch out
Common mistakes.
- Assuming DFL stays the same as profits change. It is calculated at one profit level and moves as EBIT and interest move.
- Confusing financial leverage with operating leverage. DFL looks at debt costs, whereas operating leverage looks at fixed operating costs.
- Thinking higher DFL is always bad. Moderate leverage can raise returns, but a very high figure makes a business vulnerable.
Questions
People also ask.
What is a good DFL?
There is no universal answer because it depends on the industry and how stable profits are. Stable businesses such as utilities can handle a higher DFL than cyclical ones, whose sales rise and fall with the economy.
What does a DFL of 1 mean?
It means the company has no interest expense, so earnings move in line with operating profit. This also means no leverage effect on returns.
Can DFL be negative?
Yes, if interest exceeds EBIT, the result is negative or undefined. This signals that the business is not covering its interest costs.
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