Formula to Calculate Degree of Financial Leverage
Degree of financial leverage formula calculates the change in net income occurring because of change in earnings before interest and taxes of the company; it helps in determining how sensitive the profit of the company is to the changes in the capital structure.
Degree of financial leverage (DFL) refers to the sensitivity of net income to the fluctuation caused by a change in the capital structure, and it revolves around the concept that is used in the evaluation of the amount of debt that a company is required to repay.
The formula is derived by dividing the percentage change in the net income by the percentage change in the earnings before interest and taxes (EBIT) and mathematically, it is represented as,
On the other hand, it can also be derived by EBIT divided by the earnings before taxes (EBT) of the company, which is mathematically represented as,
Step by Step Calculation
Step 1: Firstly, determine the net income of a particular year from the income statement. Then, calculate the percentage change in net income by subtracting the net income of the previous year from that of the current year and then dividing the result by the net income of the previous year.
% change in net income = (Net income current year – Net income previous year) / Net income previous year * 100%
Step 2: Next, determine the EBIT for a particular year by adding back the interest expense and taxes to the net income, all of which are line items from the income statement. Then, calculate the percentage change in EBIT by subtracting the EBIT of the previous year from that of the current year and then dividing the result by the EBIT of the previous year.
% change in EBIT = (EBIT current year – EBIT previous year) / EBIT previous year * 100%
Step 3: Finally, the DFL Formula can be calculated by dividing the percentage change in net income (step 1) by the percentage change in EBIT (step 2), as shown above.
The second formula for the calculation of the degree of financial leverage can be derived by using the following steps:
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Step 1: Firstly, determine the net income from the income statement and then calculate the EBIT of the company by adding back the interest expense and taxes to the net income.
EBIT = Net income + Interest expense + Taxes
Step 2: Next, calculate the EBT of the company by deducting the interest expense from the EBIT.
EBT = EBIT – Interest expense
Step 3: Finally, the DFL formula can be calculated by dividing the EBIT of the company (step 1) by the EBT (step 2), as mentioned above.
Degree of Financial Leverage Examples
Let’s see some simple to advanced examples to understand it better.
Example #1
Let us take the example of Company XYZ Ltd, which has clocked net income of $400,000 in the current year vis-à-vis $300,000 in the previous year. In the current year, the interest expense and taxes of the company stood at $59,000 and $100,000 respectively, while in the previous year it stood at $40,000 and $90,000 respectively. Determine the DFL for Company XYZ Ltd.
Use the following data for the calculation of the degree of financial leverage formula.
For the calculation of a degree of financial leverage first, we will calculate the following values,
% Change in Net Income
% Change in Net Income = Change in net income / Net income previous year * 100%
= $100,000 / $300,000 * 100%
= 33.33%
EBIT for Current Year
EBIT current year = Net income current year + Interest expense current year + Taxes current year
= $400,000 + $59,000 + $100,000
= $559,000
EBIT for Previous Year
EBIT previous year = Net income previous year + Interest expense previous year + Taxes previous year
= $300,000 + $40,000 + $90,000
= $430,000
% Change in EBIT
% change in EBIT = Change in EBIT / EBIT previous year * 100%
= $129,000 / $430,000 * 100%
= 30.00%
Now, the calculation of the degree of financial leverage formula is as follows,
- DFL Formula = % change in net income / % change in EBIT
- DFL Formula= 33.33% / 30.00%
Degree of Financial Leverage will be –
DFL = 1.11
Therefore, a 1% change in the XYZ Ltd’s leverage will change its operating income by 1.11%.
Example #2
Let us take the example of another Company, ABC Ltd, which has a clocked net income of $200,000 as per the last reported annual result. The interest was charged at 5% on an outstanding debt of $1,000,000, and taxes paid was $25,000. Determine the DFL for Company ABC Ltd.
Use the following data for the calculation of the degree of financial leverage.
Where Interest expense = Interest rate * Outstanding debt
= 5% * $1,000,000
= $50,000
For the calculation of the degree of financial leverage formula first, we will calculate the following values,
EBIT
EBIT = Net income + Interest expense + Taxes paid
= $200,000 + $50,000 + $25,000
= $275,000
EBT
EBT = Net income + Interest expense
= $200,000 + $25,000
= $225,000
Now, the calculation of degree of financial leverage formula is as follows,
- DFL Formula = EBIT / EBT
- DFL Formula = $275,000 / $225,000
Degree of Financial Leverage will be –
DFL = 1.22
Therefore, a 1% change in ABC Ltd’s leverage will change its operating income by 1.22%.
Calculator
You can download this Degree of Financial Leverage Calculator.
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Relevance and Use
It is important to understand the concept of the degree of financial leverage because it indicates the relationship between the capital structure of a company and its operating income. A low ratio is indicative of the low percentage of debt in a company’s capital structure, which again indicates that the sensitivity of the net income to the fluctuation in operating income is low, and as such, these companies are more stable. On the other hand, a high ratio indicates a higher percentage of debt in a company’s capital structure, and these companies are vulnerable because their net income is more responsive to fluctuations in operating income.
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