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.
Formula
Degree of Financial Leverage = % Change in EPS / % Change in EPS
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.
Example
Interpretation
Leverage is very dangerous unless the company is reasonably certain of its earnings. Investors view the leverage ratio with great detail. This is because it enables a small change in the EBIT to completely wipe out the companys capital and make it insolvent almost overnight.
Related Articles
- Equity to Fixed Assets Ratio
- Proprietary Ratio
- Interest Coverage Ratio
- Degree of Operating Leverage Ratio
- Degree of Combined Leverage Ratio

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