Financial Leverage
Financial leverage can be outlined as the degree to which a company employs fixed-income securities, such as debt and preferred equity. With a large degree of financial leverage arrives huge interest payments. As a result, the the line that shows profit or loss net income per share is negatively affected by interest payments. As interest payments raise as a outcome of raised financial leverage, Earnings Per Share is beaten back to lower.
Financial risk is the chance to the stockholders that is brought on by an increase in debt and preferable equities in a capital structure of the company. As a company enhances debt and preferred equities, interest payments enhances, cutting down Earnings Per Share. As a outcome, risk to stockholder bring back is increased. A company should keep its optimal capital structure in mind when bringing in financing conclusions to ensure any increases in debt and preferred equity increase the value of the company.
Degree of Financial Leverage
The degree of financial leverage is earnings before interest and taxes, divided by earnings before taxes and the formula of DFL is as follows:
Earnings before interest and taxes / Earnings before taxes
The degree of financial leverage computes the proportional change in net income that is caused by a change in the capital structure of a business to either increase or decrease the amount of debt. This measurement, to a very great extent be employed to model the proportional change in net income caused by a change in the interest rate in case if the amount of debt remains the same.
The degree of financial leverage is practicable for modeling what may happen to the net income of a business in the future, based on varies in its operating income, interest rates, or amount of debt burden. In particular, when debt is added to a business, this brings in interest expense, which is a fixed cost. For the reason that interest cost is a fixed cost, it increases the breakeven point at which a business begins to turn a profit. The outcome is by and large a higher level of risk, where a company can earn a great deal more money above its make neither profit nor loss level, but the higher make neither profit nor loss level to a very great extent. It means that there is a higher risk of losses if sales dip below the higher make neither profit nor loss level.
The metric can to a very great extent be employed to compare the results of several businesses to see which ones have more financial risk built into their capital structures. This information might lead an investor to purchase the shares of a company with a higher degree of financial risk during an flourishing economy, on account of, it should earn larger than normal for its kind profits on higher sales volume. In converse manner, the similar information would lead an investor to purchase the shares of a company with a lower degree of financial risk during a contracting economy, since its lower breakeven point should mitigate its losses.
For instance , in Year 1, XYZ International has no debt and earns $80,000 before interest and taxes. Since there is no debt, the earnings before taxes is the same number. Therefore, the degree of financial leverage is 2.00, which is quite conservative. In Year 4, the management of XYZ takes on debt in order to expand the business. The outcome is earnings before interest and taxes of $140,000, while $40,000 of interest expense reduces the earnings before taxes to $100,000. This means that the degree of financial leverage has increased to $140,000 / $100,000, or 2.8. This means that, for every $2 change in earnings before taxes, there is a 2.8x alteration in earnings before interest and taxes.
Thus, a higher number indicates a higher degree of financial leverage, which can be considered a higher degree of risk, especially if earnings from operations decline while the interest expense remains.
The formula for the degree of financial leverage can to a very great extent be expressed as:
Earnings per share / Earnings before interest and taxes
By aggregating the degree of operating leverage with the degree of financial leverage we obtain the degree of total leverage (DTL). If a business firm has a high amount of operating leverage and financial leverage, a small alteration in sales will lead to a large variability in Earnings Per Share. This measurements the percentage change in earnings per share over the percentage change in EBIT. This is known as degree of financial leverage or DFL. It is the measurement of the sensitivity of Earnings Per Share to varies in EBIT as a outcome of alters in debt.
|
Degree of Financial Leverage= percentage change in Earnings Per Share
Percentage change in EBIT - Interest
|
A shortcut to keep in mind with Degree of Financial Leverage is that, if interest is 0, then the DLF will be equal to 1.
Financial Leverage - Online Tutoring - Assignment Assistance
We at Expertsmind.com offer Financial Leverage homework help, Financial Leverage free tutorials and assignment assistance and Financial Leverage based question's answers by help of qualified and experienced finance tutors. We make easy Financial Leverage based assignments and homework for you with conceptual Leverage theory.
ExpertsMind.com - Financial Leverage Assignment Help, Financial Leverage Homework Help, Financial Leverage Assignment Tutors, Financial Leverage Solutions, Financial Leverage Answers, Types of Leverage Assignment Tutors