Degree of Financial Leverage Ratio
A high debt equity ratio makes the company financed by debt more than
by equity. Therefore there are fixed interest payments involved. Hence
when the going is good, the company makes a handsome return as a small
percentage of change in EBIT creates a large percentage change in
earnings per share. However the inverse of this is also true. Just like
financial leverage helps to magnify profits, it also magnifies losses
when EBIT fall down. Analysts want to quantify exactly how much
variability does debt funding create in the operations of a particular
company and have created a measure called “Degree of Financial Leverage”
which we will study in detail.
There is a reasonable assumption about the absence of any changes in accounting policy which would make the EPS and EBIT figures incomparable from the previous years.
Formula
Degree of Financial Leverage = % Change in EPS / % Change in EPSThere is a reasonable assumption about the absence of any changes in accounting policy which would make the EPS and EBIT figures incomparable from the previous years.
Example
- Profit Magnification Example: The best example of
degree of financial leverage is in the field of home ownership. Let’s
say that you brought a house for Rs 100. It is financed 30% by own money
and 70% by debt bearing interest of 10%.
Thus, you are obligated to pay Rs 7 interest each year, regardless of
what happens. Lets say that the price of the house went up by 20% to
120. In this case you will pay back the creditors Rs 77 (principal +
interest) and be left with Rs 43. Since your original investment was Rs
30, you have gained Rs 13.
A price increase of 20% has led to an increase in the shareholders return by approximately 43%!
- Loss Magnification Example: Let’s say that you brought the same house for Rs 100. It is financed 30% by own money and 70% by debt bearing interest of 10%.
Thus, you are obligated to pay Rs 7 interest each year, regardless of
what happens. Lets say that the price of the house went down by 20% to
Rs 80. In this case you will pay back the creditors Rs 77 (principal +
interest) and be left with Rs 3. Since your original investment was Rs
30, you have lost Rs 27.
A price decrease of 20% has led to a decrease in the shareholders return by approximately 90%