What is a degree of financial leverage – LDF?
A degree of financial leverage (LDF) is a leverage ratio that measures the sensitivity of a company’s earnings per share (EPS) to fluctuations in its operating profit, due to changes in its capital structure. The degree of financial leverage (LDF) measures the percentage change in EPS for a unit change in operating profit, also called profit before interest and taxes (EBIT).
This ratio indicates that the higher the level of financial leverage, the more volatile the profits. Since interest is usually a fixed expense, leverage increases returns and EPS. It’s a good thing when operating profit increases, but it can be a problem when operating profit is under pressure.
The formula for DFL is
LDF=%change in EBIT%change of EPSTheThe
DFL can also be represented by the equation below:
LDF=EBIT – interestEBITTheThe
Degree of financial leverage (LDF)
What does the degree of financial leverage tell you?
The higher the LDF, the more volatile the earnings per share (EPS) will be. Since interest is a fixed expense, leverage boosts returns and EPS, which is good when operating profit increases, but can be a problem during difficult economic times when operating profit is under pressure.
The DFL is invaluable in helping a business assess the amount of debt or leverage it should choose for its capital structure. If operating profit is relatively stable, profits and EPS will also be stable, and the company can afford to incur significant debt. However, if the business operates in a sector where operating profit is quite volatile, it may be prudent to limit the debt to easily manageable levels.
The use of leverage varies considerably by industry and business sector. There are many industrial sectors in which companies operate with a high degree of financial leverage. Retail stores, airlines, grocery stores, utility companies and banking institutions are classic examples. Unfortunately, the excessive use of financial leverage by many companies in these sectors has played a key role in forcing many to file for Chapter 11 bankruptcy.
Examples include R.H. Macy (1992), Trans World Airlines (2001), Great Atlantic & Pacific Tea Co (A&P) (2020) and Midwest Generation (2020). In addition, the excessive use of financial leverage was the main cause of the financial crisis in the United States between 2007 and 2009. The disappearance of Lehman Brothers (2008) and many other highly leveraged financial institutions are perfect examples of the negative ramifications associated with it. with the use of highly indebted capital structures.
Key points to remember
- The degree of financial leverage (LDF) is a leverage ratio that measures the sensitivity of a company’s earnings per share to fluctuations in its operating profit, due to changes in its capital structure.
- This ratio indicates that the higher the level of financial leverage, the more volatile the profits.
- The use of leverage varies considerably by industry and business sector.
Example of use of DFL
Take the following example to illustrate the concept. Suppose that the hypothetical BigBox Inc. has an operating profit or profit before interest and taxes (PBIT) of $ 100 million in the first year, with interest expense of $ 10 million, and at $ 100 million shares outstanding. (For the sake of clarity, let’s ignore the effect of taxes for now.)
The EPS for BigBox in 1st year would therefore be:
100 million shares outstandingOperating profit of $ 100 million – Interest costs of $ 10 millionThe=$0.90The
The degree of financial leverage (LDF) is:
$ 100 million – $ 10 million$ 100 millionThe=1.11The
This means that for each 1% change in EBIT or operating profit, EPS would change by 1.11%.
Now suppose BigBox records a 20% increase in operating profit in the second year. In particular, interest charges remain unchanged at $ 10 million the second year also. The EPS for BigBox in year 2 would therefore be:
100 million shares outstandingOperating profit of $ 120 million – Interest costs of $ 10 millionThe=$1.10The
In this case, EPS increased from 90 cents in the first year to $ 1.10 in the second year, representing a change of 22.2%.
This could also be obtained from the number DFL = 1.11 x 20% (variation EBIT) = 22.2%.
If the EBIT had instead decreased to $ 70 million in the second year, what would have been the impact on EPS? EPS would have decreased by 33.3% (i.e. an LDF of 1.11 x -30% variation in EBIT). This can be easily verified since the EPS, in this case, would have been 60 cents, which represents a decrease of 33.3%.