How to Calculate Financial Leverage?
Calculating financial leverage involves determining the degree to which a company uses debt to finance its assets. The most common way to measure financial leverage is through various ratios that compare debt to equity or assess the impact of debt on earnings. Here are the steps to calculate financial leverage using two common metrics: the Debt-to-Equity Ratio and the Degree of Financial Leverage (DFL).
1. Debt-to-Equity Ratio
The Debt-to-Equity Ratio is a measure of the company’s financial leverage that compares its total liabilities to its total shareholders’ equity. This ratio indicates how much debt is used to finance the company’s assets relative to equity.
Formula of Debt-to-Equity Ratio:
Debt-to-Equity Ratio = Total Debt/Total Equity
Example of Debt-to-Equity Ratio:
If a company has total debt of $500,000 and total equity of $1,000,000:
Debt-to-Equity Ratio = 500,000/1,000,000 = 0.5
Debt-to-Equity Ratio = 0.5
This means the company has $0.50 of debt for every dollar of equity.
2. Degree of Financial Leverage (DFL)
The Degree of Financial Leverage measures how much a company’s earnings before interest and taxes (EBIT) will change in response to a change in operating income due to the fixed costs of debt (interest expenses).
Formula of DFL:
DFL = EBIT/EBIT−Interest Expenses
Example of DFL:
If a company has EBIT of $200,000 and interest expenses of $50,000:
DFL = 200,000/200,000−50,000 = 1.33
This means that a 1% change in EBIT will result in a 1.33% change in net income.
3. Additional Metrics (Equity Multiplier)
Equity Multiplier: Another measure of financial leverage, calculated as:
Formula of Equity Multiplier:
Equity Multiplier = Total Assets/Total Equity
This ratio indicates the proportion of assets financed by equity.
Example of Equity Multiplier:
If a company has total assets of $1,500,000 and total equity of $1,000,000:
Equity Multiplier = 1,500,000/1,000,000 = 1.5
This means that for every dollar of equity, the company has $1.50 in assets.