Question

A company's sales have increased from $1,107,900 to $1,309,225. Its operating income has increased from $232,000 to $315,937, and its earnings per share increased from 1.30 to 1.50. Calculate the degree of financial leverage.

Answer 1

Financial Leverage arises due to the presence of fixed financial costs (such as interest) in the cost structure of the company.

It implies that a given percentage change in EBIT results into more than proportionate change in EPS of the company in the same direction. It measures the sensitivity of a company's EPS to a given change in its operating profit (EBIT).

Degree of Financial Leverage (DFL) = % Change in EPS / % Change in EBIT

Here,

Original EBIT = $232,000

New EBIT = $315,937

Change in EBIT = ($315,937 - $232,000)/ $232,000 * 100 = $83,937 / $232,000 * 100 = 36.17%

Original EPS = 1.30

New EPS = 1.50

Change in EPS = (1.50 - 1.30)/ 1.30 * 100 = 0.2/ 1.30 * 100 = 15.38%

DFL = % change in EPS/ % Change in EBIT

= 15.38% / 36.17%

= 0.42