- DFL = (% of change in net income) / (% of change in the EBIT) In this formula, the percent change in a company’s earnings before interest and taxes (EBIT) divides into the percent change of the company’s net income.
- DFL = (EBIT) / (EBT)
Degree of Financial Leverage (DFL)
Importance of the degree of financial leverage
Understanding how operational costs, liabilities, and expenses affect revenue and income requires having a solid understanding of financial leverage. Financial analysts and accountants can use this ratio to track erratic changes in earnings and to analyze how businesses can streamline their operations to pay off debts, reduce costs, and pay less in mandatory corporate taxes.
A company can use the degree of financial leverage to determine how much debt it can take on and still turn a profit. A company can take on more debt if its operating income is stable, which also affects its EPS and total earnings.
What is the degree of financial leverage?
The DFL is a percentage that financial experts use to show changes in a company’s net income due to changes in its earnings before interest and taxes (EBIT). The DFL ratio can demonstrate how much financial leverage a company has, which has an impact on how volatile its earnings are. Businesses assess their financial health and long-term success using the ratio of financial leverage.
Degree of financial leverage formulas
Two formulas can be used by financial experts to determine the level of financial leverage:
1. DFL = (% of change in net income) / (% of change in the EBIT)
By dividing the percent change in a company’s earnings before interest and taxes (EBIT) by the percentage change in net income, this formula calculates a company’s overall performance.
2. DFL = (EBIT) / (EBT)
The second DFL formula can be used to determine the DFL using an organization’s earnings before taxes (EBT). Using this formula, a company’s EBT is created and divided into its EBIT.
How to calculate degree of financial leverage
Use the following formula, following the steps outlined below, to determine the DFL using percent changes in net income and your company’s EBIT:DFL = (% of change in net income) / (% of change in the EBIT)
1. Calculate the net income
Use the following formula to determine the net income for the time period you are measuring:
(Revenue) – (COGS) – (expenses)
For instance, if a company that manufactures and sells cellphone cases generates revenue of $55,000 and must pay expenses of $7,500 as well as costs of goods sold (COGS) of $15,000, it determines its net income as:
($55,000) – ($15,000) – ($7,500) = $32,500
2. Find the percent change in net income
To determine the DFL, you must be aware of the percentage change in net income. You can determine this percentage with the following formula:
[(current net income – (previous net income)] / (previous net income) x 100 = % of change in net income
Assuming the company continues to calculate its DFL and determines its percent change in net income if its net income for the prior period was $29,900, using the previous example business:
Net income change as a percentage equals [(32,500-29,900)] / ($29,900) x 100 = 8 7%.
The resulting percentage indicates that the company’s revenue rises by 8 7% from the previous period.
3. Find the earnings before interest and tax (EBIT)
Since this value represents a company’s true earnings before it pays its taxes and any interest that has accrued on debt, the EBIT is defined as net income plus interest and taxes. Knowing your EBIT for the current and prior periods is necessary to calculate the percent change in EBIT.
Assume, for instance, that the business uses the following formula to determine its EBIT in the previous business example:
Its EBIT is calculated as (net income) + (interest) + (tax)**, which equals $32,500 + $17,000 + $6,500.
4. Calculate the percent change in your EBIT
Use the following formula to determine the percent change in EBIT after calculating EBIT:
(current EBIT – prior EBIT) / (previous EBIT) x 100 = % of change in EBIT
Calculate the percent change in EBIT using the current value of $56,000 and a prior EBIT of $54,400 using the cellphone case business as an example:
EBIT percentage change equals (2%) ($56,000 – $54,400) / ($54,400) x 100. 95%.
The percent change in EBIT is 2. 95%, indicating an increase in earnings from the previous period.
5. Divide the percent changes in net income and EBIT
Divide these two figures by the percent changes in net income and EBIT to obtain the DFL.
DFL is equal to (% of change in net income) divided by (% of change in EBIT).
DFL = (8. 7%) / (2. 95%) = 2. 95%, resulting in a DFL value of 2 for the example values. 95%.
6. Analyze the result
You can use the results to determine how much debt your company or organization can reasonably handle and repay once you’ve determined the level of financial leverage. The volatility of earnings increases with the percentage of DFL. If a company takes on too much additional debt and interest, it may suffer, according to a DFL value that is too high.
The example business’ DFL shows little fluctuation in income and earnings, so it can rationally accept more debt interest. Since interest is a fixed expense, the DFL is also helpful for determining how much interest on debt a business can afford over the long term.
How to calculate degree of financial leverage using EBT
Both your company’s EBIT and earnings before taxes (EBT) are used in the formula below.
DFL = (EBIT) / (EBT)
The EBT represents earnings for your business before taxes, but it also includes earnings after interest has been taken out. The following steps show you how to apply the formula:
1. Calculate the EBIT
Add interest and tax values to the current period’s net income to determine the EBIT. For instance, let’s say a service provider wants to locate its DFL. The company calculates its current period’s net income at $117,000, total interest payments of $34,000, and taxes due of $55,000 using the formula (net income) + (interest) + (tax), resulting in an EBIT of $206,000.
2. Find the EBT
Calculate the EBT by multiplying the amount of taxes your business owes by the net income after determining the EBIT. The EBT comes to $172,000 using the service provider’s example and the formula (net income) + (tax value).
3. Divide EBIT by EBT
Divide the EBT by the EBIT once you have knowledge of the EBIT and EBT to determine the amount of financial leverage for your business. The example service provider, for instance, applies the DFL formula DFL = (EBIT) / (EBT), and discovers:
DFL = ($206,000) / ($172,000) = (EBIT) / (EBT) = 2%.
The service providers degree of financial leverage is 1. 2%, indicating a lower level of earnings volatility, indicating that it could likely incur significant additional debt.
FAQ
What is a good degree of financial leverage ratio?
The following formula is used to determine financial leverage: assets x shareholders’ equity x debt ratio
How do you calculate DFL?
The ability of the company to pay interest is demonstrated by this ratio, which is calculated as operating income divided by interest expenses. Generally, a ratio of 3. Although this varies from industry to industry, 0 or higher is preferred.
What is DOL and DFL?
Divide a company’s earnings before interest and taxes by its earnings before taxes to determine its DFL. For instance, if a business made $500,000 before paying taxes and interest expenses and paid $40,000 in interest expenses during that time, its DFL would be 1. 087.
