The degree of financial leverage is a financial ratio that measures the sensitivity in fluctuations of a company’s overall profitability to the volatility of its operating income caused by changes in its capital structure. The degree of financial leverage is one of the methods used to quantify a company’s financial risk (the risk associated with how the company finances its operations).
What is Financial Leverage?
Financial leverage is a main source of financial risk. By issuing more debt, a company incurs the fixed costs associated with the debt (interest payments). The company’s inability to meet the obligations may result in financial distress or even bankruptcy.
Highly leveraged companies may face significant financial problems during a recession because their operating income will rapidly decline and, thus, so will their overall profitability. Note that taxes do not affect the degree of financial leverage.
A high degree of financial leverage indicates that even a small change in the company’s leverage may result in a significant fluctuation in the company’s profitability. Also, a high degree of leverage may translate to a more volatile stock price because of the higher volatility of the company’s earnings. Increased stock price volatility means the company is forced to record a higher expense for outstanding stock options, which represents a higher cost of debt. Therefore, companies with extremely volatile operating incomes should not take on substantial leverage because there is a high probability of financial distress for the business.
Formula for Degree of Financial Leverage
There are several ways to calculate the degree of financial leverage. The choice of the calculation method depends on the goals and context of the analysis. For example, a company’s management often wants to decide whether it should or should not issue more debt. In such a case, net income would be an appropriate measure of the company’s profitability:
However, if an investor wants to determine the effects of the company’s decision to incur additional leverage, the earnings per share (EPS) is a more appropriate figure because of the metric’s strong relationship with the company’s share price.
Finally, there is a formula that allows calculating the degree of financial leverage in a particular time period:
Example of Degree of Financial Leverage
ABC Corp. is preparing to launch a new project that will require substantial external financing. The company’s management wants to determine whether it can safely issue a significant amount of debt to finance the new project. Currently, the company’s EBIT is $500,000, and interest payments are $100,000.
In order to make the decision, the company’s management wants to examine its degree of financial leverage ratio:
It shows that a 1% change in the company’s leverage will change the company’s operating income by 1.25%.
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