Financial Leverage

Financial leverage is the use of debt and other fixed-charge financing in a business’s funding mix, so that a change in earnings before interest and taxes (EBIT) produces a larger proportional change in earnings per share and in return on equity. The magnification is symmetric: the same structure that turns a rise in EBIT into a larger rise in EPS turns a fall into a larger fall.

The financial management curriculum of the Institute of Chartered Accountants of India (ICAI) calls financial leverage a double edged sword. Where the cost of those fixed-cost funds sits below the return on investment it lifts return on equity and EPS; where the cost of debt runs above that return, both move the other way (ICAI, Financing Decisions - Leverages). The mix being used is capital structure; financial leverage is what using it does to the owners’ return.

The Degree of Financial Leverage

The measure that belongs to this term is the degree of financial leverage (DFL). ICAI states it as the ratio of the percentage change in EPS to the percentage change in EBIT, and defines financial leverage itself as the ability of a firm to use fixed financial charges to magnify the effect of changes in EBIT on EPS (ICAI, Financing Decisions - Leverages).

DFL  =  percent change in EPS / percent change in EBIT

DFL  =  EBIT / (EBIT - interest)

DFL  =  EBIT / ((EBIT - interest) - preferred dividend / (1 - tax rate))

The first is the definition; the other two are that definition with the algebra done. The second holds where no preferred stock is outstanding, and equals EBIT over earnings before tax. The third is general: a preferred dividend is paid out of profit after tax, so it is grossed up by one less the tax rate before joining the interest below the line (ICAI, Financing Decisions - Leverages).

A DFL above one means financial leverage exists, and a higher DFL means more of it. Where the denominator is nil the ratio is undefined, and that happens at the financial break-even point, the level of EBIT at which EPS is zero, which is simply the interest amount where no preferred stock is outstanding (ICAI, Financing Decisions - Leverages).

Sensitivity to sales is the matching measure on the operating side. Operating leverage runs from sales volume to EBIT, and the split between the business risk it indicates and the financial risk this one indicates is set out at operating leverage along with its degree. The two multiplied give combined leverage, the percentage change in EPS over the percentage change in sales (ICAI, Financing Decisions - Leverages).

A Worked Example

Say two companies earn the same EBIT and differ only in funding. The second replaced part of its equity with borrowing, so it carries more interest and fewer shares. Tax is a flat quarter of pre-tax earnings, and neither has preferred stock outstanding.

                                     Low debt      High debt
EBIT                                  200,000        200,000
Interest                              (40,000)      (100,000)
Earnings before tax                   160,000        100,000
Tax                                   (40,000)       (25,000)
Earnings after tax                    120,000         75,000
Shares outstanding                    120,000         75,000
EPS                                      1.00           1.00

DFL    EBIT / (EBIT - interest)          1.25           2.00

Both columns open at the same EPS, so the level says nothing on its own. Now hold the interest and the share counts and move EBIT a fifth each way.

EBIT a fifth higher                   240,000        240,000
EPS                                      1.25           1.40
change in EPS                             25%            40%

EBIT a fifth lower                    160,000        160,000
EPS                                      0.75           0.60
change in EPS                            (25%)          (40%)

Each column moved by its own DFL, up and down alike, and nothing about the operations differed between them.

Where a Preparer Meets Financial Leverage

The interest in the denominator comes off the non-operating stretch of the income statement, the caption read in times interest earned. Behind it sits the debt schedule, splitting each payment into the period’s interest and the principal that reduces the balance, and drawing off the portion due inside a year, as long-term liabilities sets out.

A credit agreement uses the word leverage for a different figure, usually capping a balance sheet or debt-to-EBITDA leverage ratio and flooring a coverage ratio, with the agreement’s own definitions clause governing both figures rather than the accounting, the ground covenants covers.

Operating lease liabilities now sit on the balance sheet, so renewing an office lease lifts a total-liabilities leverage reading while the debt schedule is untouched, worked through in debt to asset ratio analysis.

What Financial Leverage Is Confused With

The phrase financial leverage ratio is also used for a balance sheet reading of the mix rather than for this EPS magnification, and that ratio is defined at the equity multiplier, where it also sits as the third factor in DuPont analysis. Published definitions split between the two, so confirm which one a document means before comparing anything; the wider family of measures on the mix is at debt ratios.

The bare phrase leverage ratio is looser still, and none of its senses is the DFL. In federal bank supervision, liabilities-to-assets leverage ratio is a defined threshold term, set out at asset to liabilities ratio. Inside a CPA firm’s own practice reporting it names a staffing ratio instead, a sense the equity multiplier covers alongside the firm KPI benchmarks.

Common Questions

Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a trial task lets a firm’s own reviewer grade a real block of its debt schedule and covenant work before any client file depends on it.