The degree of financial leverage (DFL) is the coefficient by which a proportional change in net income and fluctuations in operating income of a company due to changes in the capital structure of business are calculated. This degree is used to estimate the amount of debt to be paid. Thus, the formula for calculating the degree of financial leverage is:
DFL = Earnings before interest and taxes ÷ Earnings before taxes
Explanation:
Financial Leverage Degree (DFL) is a useful tool that is used to model possible changes in net business income in the future, given changes in interest rates or operating income. DFL also allows you to calculate the forecast of revenue for the business when adding a debt burden to it, leading to interest expenses. Since these expenses are fixed, their increase reduces the profit and decreases the company’s profitability.
The result of this decrease is usually an increased level of risk. Thus a high degree of financial leverage shows that even a small change in leverage can lead to very significant fluctuations in profit. Companies with high DFLs are prone to financial problems during the recession, as their overall profitability will decline at a breakneck pace.
This tool can also be used to compare different companies and find out which of the companies in question has a more significant financial structural risk of capital. Knowing both this information and the state of the economy, a choice regarding investments in this or that company can be made.
In a growing economy, it makes sense to invest in a company with high risks to maximize revenue; however, in a shrinking economy, to mitigate losses, an investor needs to pay attention to a company with less risk. Thus, this method allows to make a probabilistic forecast of the financial performance of various companies and make a decision on investing in a company in multiple economic conditions.