FINANCIAL LEVERAGE

Financial leverage (Debree of financial leverage, DFL) measures of the amount of debt used by a firm.

Degree of financial leverage = % change EPS/ % change EBIT

Financial leverage measures the sensitivity of a firmís earnings per share to a change in operating income.

A B C
EBIT 20 20 20
Interes expenses 0 4 6
Taxes
Net Income 20 16 14
Number of shares 100 50 25
EPS 0.20 0.32 0.56


DFL ratios include:

Debt ratio
Debt equity ratio
Times interest earned ratio
Cash flow to debt ratio

Debt Ratio = TL/TA = Total Liabilities/Total Assets

Debt/Equity ratio = D/SE = Total debt/Shareholders Equity

Times Interest Earned (TIE) = EBIT/I

TIE = Earnings Before Interest and Taxes/Interest Expenses

Cash Flow to Debt Ratio = CFO/D

CF/D = Cash Flow from Operations/ Total Debt

Financial leverage, Example:
r = 15 %
D = 1500 000
E = 500 000
i = 8 %
L = 1500 000/500 000 = 3.0
re = r + (r Ė i) x L
= 15 % + (15 % - 8 %) x 3.0 = 36 %
Assume D to be 2500 000 i.e L = 5.0 then
re = 50 %

At a high level of EBIT leverage is beneficial because leverage increases ROE and EPS.