Fundamental analysis uses the degree of financial leverage (DFL) to determine the sensitivity of a company’s earnings per share (EPS) when there is a change in its earnings before interest and taxes (EBIT). When a business has a high DFL, it usually has high interest payments, which negatively impacts EPS.
Degree of financial leverage
DFL determines the percentage change in a company’s EPS per unit change in its EBIT. A company’s DFL is calculated by dividing its percentage change in EPS by the percentage change in EBIT over a certain period. It can also be calculated by dividing a company’s EBIT by its EBIT minus interest expense.
Earnings per share
EPS is used to determine the profitability of a business. EPS is calculated by subtracting dividends paid to shareholders from a company’s net income. The resulting value is divided by the outstanding shares of the company.
How the degree of financial leverage affects earnings per share
A higher DFL ratio means that a company’s EPS is more volatile. For example, suppose Company ABC in its first year has $ 50 million EBIT, $ 15 million interest expense, and 50 million shares outstanding. The resulting EPS of ABC Company is 70 cents, or ($ 50 million – $ 15 million) ÷ 50 million shares.
In its second year, ABC Company has an EBIT of $ 200 million, interest expense of $ 25 million, and shares outstanding of $ 50 million. Its resulting EPS is $ 3.50, or ($ 200 million – $ 25 million) ÷ 50 million shares.
The resulting DFL for company ABC is 1.33, or 400% 300%.
Or, [($3.50 – $0.70) ÷ $0.70] ?? [($200 million – $50 million) ÷ $50 million].
Therefore, if the company’s EBIT increases or decreases by 1%, the DFL indicates that its EPS increases or decreases by 1.33%.