The degree of financial leverage is concerned with the relationship between
A. changes in volume and changes in EPS.
B. changes in volume and changes in EBIT.
C. changes in EBIT and changes in EPS.
D. changes in EBIT and changes in operating income.
The correct answer and explanation is:
The correct answer is C. changes in EBIT and changes in EPS.
The degree of financial leverage (DFL) measures the sensitivity of a company’s earnings per share (EPS) to changes in its operating income, specifically its earnings before interest and taxes (EBIT). This concept reflects the impact of a company’s capital structure (the proportion of debt to equity financing) on its profitability.
Financial leverage arises when a company uses fixed financial costs, such as debt interest, to amplify the potential returns on its equity. A high level of debt means the company must pay interest on its debt regardless of how well the business performs. Therefore, small changes in EBIT can lead to larger changes in EPS. This magnifying effect is what is measured by the degree of financial leverage.
When EBIT increases, the additional income contributes to covering the fixed interest costs first, with the remaining portion flowing directly to the shareholders as an increase in EPS. Conversely, if EBIT decreases, the fixed costs (interest payments) must still be met, leading to a more significant decrease in EPS than the initial drop in EBIT.
DFL is calculated as the percentage change in EPS divided by the percentage change in EBIT. A higher DFL means that a company is more leveraged, and its EPS is more sensitive to changes in EBIT. While financial leverage can enhance returns when business performance is good, it also increases risk. If a company has high leverage and faces a drop in EBIT, the negative impact on EPS will be more significant, which could strain the company’s financial health.
Understanding DFL helps investors and managers assess the risk and potential reward from a company’s financial structure, providing insight into how changes in business performance could affect shareholder value.