Degree of Financial Leverage

Interest on debt is a fixed cost. Once it is covered, any extra operating profit goes entirely to shareholders, so earnings per share rise faster than operating profit. When operating profit falls, earnings per share fall faster.

DFL can be calculated as operating profit divided by operating profit minus interest. For example, a company with operating profit of 100,000 and interest of 50,000 has a DFL of 2. A 10% increase in operating profit would raise earnings per share by about 20%.

A company with no debt has a DFL of 1, meaning earnings move in line with operating profit. The more debt a company carries relative to its profits, the higher its DFL.

Financial leverage can boost returns for shareholders in good times, but it also increases the risk of losses and financial distress when profits fall. DFL combined with the degree of operating leverage gives the degree of combined leverage, showing the total sensitivity of earnings to sales.