This video discusses the concept of “Degree of Financial Leverage”. Please refer to the “Degree of Operating Leverage” for comparison. The following is a part of the transcript. The video requires flash 8 or higher.

Here we continue the second part of the “simplified Income Statement”:

Gross Sales (Quantity X Price, QP)

-          Total Variable Cost (TVC = Q X VC)

-          Fixed Cost (FC)

= Earnings Before Interest and Tax (EBIT)

-          Interest Cost (I)

-          Tax (T)

= Earnings (per share) (EPS)

Degree of Financial Leverage (DFL) measures the percentage change of EPS for every percentage change of EBIT:

DFL = %DEPS /%DEBIT

It can be derived that,

DFL = EBIT/(EBIT-I)

This is an important measurement of the financial risk of a company. It is also important to realize that interest I is a result of debt. The reason a company borrows debts is to have financial leverage so that when the EBIT increases, EPS will increase in higher rate. However, financial leverage is a double-edged sword – it magnifies the profit as well as the loss. That’s why DFL is also a measure of the financial risk.

You may have noticed that tax does not appear in the 2^nd equation. The reason is that tax is dependent on EBIT. If you go through the math, due to this reason, it is cancelled out unlike the I or the FC and VC in the DOL equation.