Degree Of Financial Leverage Formula Step By Step Calculation

Formula to Calculate Degree of Financial Leverage

The degree of financial leverage (DFL) refers to net income sensitivity to the fluctuation caused by a change in the capital structure. It revolves around the concept used to evaluate 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 taxesEarnings Before Interest And TaxesEarnings before interest and tax (EBIT) refers to the company’s operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization’s profit from business operations while excluding all taxes and costs of capital.read more (EBIT), and mathematically, it is represented as,

Formula = % change in Net income / % change in EBIT

On the other hand, it can also be derived by EBIT divided by the earnings before taxesEarnings Before TaxesPretax income is a company’s net earnings calculated after deducting all the expenses, including cash expenses like salary expense, interest expense, and non-cash expenses like depreciation and other charges from the total revenue generated before deducting the income tax expense.read more (EBT) of the company, which is mathematically represented as,

Formula = EBIT / EBT

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Step by Step Calculation

Degree of Financial Leverage Examples

Let’s see some simple to advanced examples to understand them better.

Firstly, determine the net income of a particular year from the income statement. Then, calculate the percentage change in net income by subtracting the previous year’s net income from that of the current year and then dividing the result by the previous year’s net income. % change in net income = (Net incomecurrent year – Net incomeprevious year)/ Net incomeprevious year* 100% Next, determine the EBIT for a particular year by adding the Interest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read moreinterest 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 = (EBITcurrent year – EBITprevious year)/ EBITprevious year* 100% 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: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 + TaxesStep 2: Next, calculate the EBT of the company by deducting the interest expense from the EBIT.EBT = EBIT – Interest expenseStep 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.

% change in net income = (Net incomecurrent year – Net incomeprevious year)/ Net incomeprevious year* 100%

% change in EBIT = (EBITcurrent year – EBITprevious year)/ EBITprevious year* 100%

The second formula for the calculation of the degree of financial leverage can be derived by using the following steps: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 + TaxesStep 2: Next, calculate the EBT of the company by deducting the interest expense from the EBIT.EBT = EBIT – Interest expenseStep 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.

Example #1

Let us take the example of Company XYZ Ltd, which has clocked a 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, they stood at $40,000 and $90,000 respectively. Determine the DFL for Company XYZ Ltd.

Use the following data to calculate 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 EBITDFL Formula= 33.33% / 30.00%

Degree of Financial Leverage will be –

DFL = 1.11

Therefore, a 1% change in 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 the taxes paid were $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

DFL Formula = EBIT / EBTDFL Formula = $275,000 / $225,000

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.

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. 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. These companies are vulnerable because their net income is more responsive to fluctuations in operating incomeOperating IncomeOperating Income, also known as EBIT or Recurring Profit, is an important yardstick of profit measurement and reflects the operating performance of the business. It doesn’t take into consideration non-operating gains or losses suffered by businesses, the impact of financial leverage, and tax factors. It is calculated as the difference between Gross Profit and Operating Expenses of the business.read more.

Formula to Calculate Degree of Financial Leverage#

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Degree of Financial Leverage Examples#

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Example #2#

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