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What Is a Degree of Financial Leverage?

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  • Written By: Osmand Vitez
  • Edited By: Kristen Osborne
  • Last Modified Date: 20 March 2014
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A degree of financial leverage is a financial ratio that helps business owners and managers calculate the amount of fixed costs in their company’s operations. For this ratio, fixed costs typically represent the amount of payments companies make for construction, facilities, and equipment. Companies with a high degree of leverage often have more volatile income or cash flow situations. Economic downturns, such as recessions and depressions, may be harder for these companies to work through since fixed costs must be paid regardless of current income levels.

This figure is calculated for a company using the following formula: percent change in earnings per share (EPS) divided by the percent change in earnings before interest and taxes (EBIT). Earnings per share is the amount of profit a company allocates to each share of common stock. The basic formula for this is net income, less preferred share dividends, divided by the average outstanding shares of a company. EBIT is a figure taken from the company’s income statement. This figure is also known as operating profit, which equals operating revenue, less operating expenses for a certain accounting period.

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As an example, someone can assume the following: in July, a company has earnings per share of $1.25 US Dollars (USD) and EBIT of $150,000 USD. In August, these numbers are $1.75 USD and $195,000 USD, respectively. The percent change for earnings per share is 40% [(1.75 – 1.25) / 1.25] while the percent change of EBIT is 30% [(195,000 – 150,000) / 150,000]. The degree of financial leverage is 1.33 (0.4 / 0.3). Companies with high financial leverage generally have more volatile earnings per share, which can create significant increases or decreases in their share value.

Earnings per share is an important figure in the business environment. Companies with high earnings are generally seen as more favorable for investments because they have a tendency to increase the investors’ financial return. Investors typically shy away from companies with high fixed costs because they represent a drain on a company’s resources, regardless of their sales revenue.

Business owners and managers can also use this calculation to create a trend analysis of fixed costs. Companies with a trend of higher fixed costs may need to implement a plan for reducing business expenses or increasing revenues to offset the increase in costs. Owners and managers can also use the degree of financial leverage as a benchmark to compare against the industry standard or a leading competitor.

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Discuss this Article

watson42
Post 4

@sunnyskys- I don't know much about economics, admittedly, but I agree with you. It can be risky to deal with a company that is higher stakes, especially in some fields. I have looked into starting my own business, and many successful small business owners especially say that low risk is best in the beginning. I suppose in some businesses it might be better to be high risk, but it depends really.

sunnySkys
Post 3

@indemnifyme - I think you're right. Obviously that would change if you guys stopped making insurance sales though. But I would say normally you probably do have a low degree of financial leverage.

I actually think that businesses with a low degree of financial leverage are the way to go. You don't want to get in debt just because you have a bad month. But if you have very high operating costs, this could easily happen.

indemnifyme
Post 2

You know, I don't know this for a fact, but I'm pretty sure the insurance agency I work for doesn't have a very high degree of financial leverage.

First of all, we sell an intangible product. When someone files a claim, the parent insurance company covers it, not our office. Of course, we don't get the customers entire premium though, but that wouldn't be a factor in the degree of financial leverage.

Second of all, our office isn't that big. I don't think we use up too much electricity. Our computers and other equipment are all paid for, so we basically just pay for the Internet, our phone service, and our office space.

Yes, I definitely think our degree of financial leverage is fairly low. So I guess the agency is pretty recession proof then.

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