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 firm’s 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 – 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.