DEGREE OF LEVERAGE

The degree of leverage (DL) is one way to calculate and analyze the leverage (risk)
associated with debt. It is especially useful as it isolates the impacts of business risk and
financial risk, and shows that for a given business risk, greater financial risk increases the
overall riskiness of the firm.
The degree of leverage analysis identifies EPS as the key variable for the firm, and sales
(in terms of quantity) as the fundamental source of uncertainty (risk).
The DL is defined as %EPS/%Q, i.e. the sensitivity of EPS to sales. This sensitivity
is measured in percent, which allows comparison of two firms, or one firm at different
levels of sales.
By definition, operating leverage (business risk) focuses on the relationship between sales
and EBIT. Therefore, we can define the degree of operation leverage (DOL) as
%EBIT/%Q.
Any additional risk of the firm must be due to financial leverage. The overall focus is on
%EPS/%Q, and part of this risk is determined by the DOL.
Algebraically,
%EPS/%Q = [%EBIT/%Q][%EPS/%EBIT] = DOL[%EPS/%EBIT].
Therefore, %EPS/%EBIT must represent the financial risk, and this term is defined as
the degree of financial leverage.
DL = %EPS/%Q = [%EBIT/%Q][%EPS/%EBIT]

(1)

DOL = %EBIT/%Q
DFL = %EPS/%EBIT
DL = [DOL][DFL]

(2)

Note that the definition of the DOL makes intuitive sense, but the definition of DFL was
defined (derived) simply from the math. In order for the DFL variable to make financial
sense, it must be the case that the value of this variable increases as the amount of debt
increases. In addition, DFL must equal one when there is zero debt, as in this case the
total risk of the firm is equal only to business risk. We will see below that the DFL
variable indeed satisfies these two requirements.
The above relationships [mainly (2)] indicate that for any level of business risk, a greater
DFL will magnify the total riskiness of the corporation. On the finance side, DOL is
taken as given, and if greater financial risk is undertaken, the total risk (DL) of the firm
increases by a greater amount.

DEGREE OF OPERATING LEVERAGE (DOL)

The degree of operating leverage (DOL) is defined as the percentage change in EBIT
(operating income) that results from a given percentage change in sales:

DOL

Percentage change in EBIT

Percentage change in sales

EBIT
.EBIT
Q
.Q

(3)

The above is the definition of DOL. The DOL measures, on a percent basis, the
sensitivity of EBIT due to a change in sales (Q).
DOL can be calculated by using (4) or (5), which are derived from (3):
Q(P - V)
Q(P - V) F

DOLQ =

(4)

Or, based on dollar sales rather than units,

DOLS =

S - VC
S - VC - F

(5)

Here Q is the initial units of output, P is the average sales price per unit of output, V is the
variable cost per unit, F is fixed operating costs, S is initial sales in dollars, and VC is
total variable costs. To analyze a single product either (4) or (5) can be used, while (5) is
used to evaluate an entire firm with many types of products, where quantity in units
and sales price are not meaningful.
DEGREE OF FINANCIAL LEVERAGE (DFL)
Operating leverage affects EBIT, whereas financial leverage affects earnings after interest
and taxes, or the earnings available to common stockholders. Financial leverage builds on
operating leverage, further magnifying the effects on EPS of changes in the level of sales.
The degree of financial leverage (DFL) is defined as the percentage change in earnings
per share that results from a given percentage change in EBIT:
DFL

Percentage change in EPS

Percentage change in EBIT

EPS/EPS
EBIT/EBIT

(6)

After some algebraic manipulation (shown below), it turns out that DFL can be
calculated by:
DFL = EBIT/[EBIT I]
(7)
2

It can be seen that DFL = 1 when debt is zero, so (as required) the DFL calculation
indicates that total risk = business risk when debt is zero. In addition, (7) shows that (as
required) DFL increases when debt increases (since I increases), increasing the overall
risk of the firm.
DERIVATION OF FORMULAS FOR CALCULATION OF DOL AND DFL
The DOL formula for calculation [(4) and (5)] is derived from (3) as follows. The change
in units of output is defined as Q. In equation form, EBIT = Q(P-V)-F, where Q is units
sold, P is the price per unit, V is the variable cost per unit, and F is the total fixed costs.
Since both price and fixed costs are constant, the change in EBIT is EBIT=Q(P - V).
The initial EBIT is Q(P-V)-F, so the percentage change in EBIT is:
Q(P - V)
Q(P - V) - F

%EBIT =

The percentage change in output is Q/Q, so the ratio of the percentage change in EBIT
to the percentage change in output is

DOL =

.Q(P-V).
Q(P-V)-F
=
Q
Q

Q(P-V)
Q(P-V)-F

] [

Q
(Q)

Q(P-V)
Q(P-V)-F

(4)

The DFL calculation formula (7) is derived as follows.

1. Recall that EBIT = Q(P - V) - F.
2. Earnings per share are found as EPS=[(EBIT - I)(1 - T)]/N, where I is interest paid, T
is the corporate tax rate, and N is the number of shares outstanding.
3. I is a constant, so I=0; hence, EPS, the change in EPS, is
EPS =

(EBIT - I)(1 - T)
N

EBIT(1 - T)
N

4. The percentage change in EPS is the change in EPS divided by the original EPS:
EBIT(1-T)
N
(EBIT-I)(1-T)
N
5.

EBIT(1-T)
N

N
(EBIT-I)(1-T)

EBIT
EBIT-I

The degree of financial leverage is the percentage change in EPS for a percentage
change in EBIT:

EBIT
EBIT-I
DFL =
EBIT
EBIT

EBIT
EBIT-I

[
3

EBIT
EBIT

EBIT
EBIT-I

(7)