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.
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.