A Guide To Leverage Ratios

6. Degree of Financial Leverage: The Degree of Financial Leverage (DFL) measures how much a company's net income or  earnings per share (EPS) is affected by changes in its operating income (EBIT) due to the use of debt. It shows how sensitive the company's profits are to changes in its operating income because of the fixed interest costs that come with debt.

The degree of financial leverage is a method used to measure a company’s financial risk, specifically the risk related to how the company finances its operations. A higher DFL means that small changes in EBIT will lead to larger changes in EPS, indicating higher financial risk due to leverage. Conversely, a lower DFL suggests that earnings are less sensitive to changes in EBIT, implying lower risk.  Essentially, DFL shows how much leverage the company has in its financial structure and how that leverage can amplify both gains and losses.

DFL = EBIT / (EBIT − Interest Expense)

This indicates that a 1% change in EBIT will result in a 2% change in EPS. If EBIT increases by 1%, EPS will increase by 2%, reflecting that the company benefits from increased operating income & vice versa.

7. Interest Coverage Ratio: The interest coverage ratio measures a company's ability to pay interest on its outstanding debt. This ratio is important for assessing a company's financial health and its risk of defaulting on interest payments. A higher ratio indicates that the company has more than enough earnings to cover its interest payments, suggesting lower financial risk and vice versa.

Interest Coverage Ratio = EBIT / Interest Expense

Types of Leverage

• Operating Leverage: Operating leverage measures how much of a company’s costs are fixed versus variable. Companies with high operating leverage have a large proportion of fixed costs, which means the companies are capital-intensive and their profits can change a lot with small changes in sales. A company with more than 50% fixed costs relative to revenue is considered to have high operating leverage, while a company with less than 20% fixed costs has low operating leverage.

• Financial Leverage: Financial leverage refers to how much debt a company uses to fund its operations. By borrowing money, a company can potentially increase its return on equity and earnings per share, as long as the returns on investment are higher than the cost of debt.

• When a company or individual takes on debt, they use borrowed funds to invest in projects or assets. If these investments generate returns that exceed the cost of the debt (i.e., the interest payments), the excess returns enhance the overall profitability. This process amplifies the returns on the equity invested. 

Risk -  If the return on investment is less than the interest rate on the debt, the company or investor will incur losses. These losses are amplified because the debt must still be serviced, regardless of the performance of the investment.

• Combined Leverage: Combined leverage looks at both operating and financial leverage together. It combines how a company’s fixed costs affect its operating income (operating leverage) with how its debt affects earnings per share (financial leverage). This gives a full picture of how both types of leverage impact the company’s overall financial performance.e of materials and goods held by a company with the intention of selling them to earn profits.

Characteristic of a Good Leverage Ratio

The appropriate level of leverage depends on the specific ratio being analyzed and the type of company. For instance, capital-intensive industries, like manufacturing, typically rely more on debt compared to service-based companies, so they generally have higher leverage. To determine what’s an acceptable level of leverage, it’s helpful to compare ratios within the same industry. It's also important to note that having very little debt isn't always ideal; companies can use debt to enhance returns for shareholders.