Tuesday, April 22, 2008

Degree of Financial Leverage

What does degree of Financial Leverage mean in an Accounting Context?


Financial leverage is very similar to operating leverage, except fixed costs that are interested in are the fixed financing costs this time around.

These are the interest expense and preferred dividends that will be issued. A company can measure financial leverage by examine percentage changes in earnings per share (EPS) to percentage changes in EBIT. This is reffered to as the degree of financial leverage formula.

Equation for Degree of Financial Leverage (DFL):

DFL = %Δ in EPS/ %Δ in EBIT

or

Degree of Operating Leverage (DOL) = Contribution Margin (CM) ÷ Net Operating Income


High-Operating Leverage and Low-Operating Leverage


A company with a high fixed cost structure will show higher net income in good years than companies with lower fixed cost structures. The reverse will happen in bad years. Leverage is a double-bladed sword.

Additional Accounting Related Information on Financial Leverage:

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