Financial Risk and Degree of Financial Leverage | CFA Level I Corporate Issuers

Welcome back as we examine the financial risk of a company and how to determine its degree of financial leverage (DFL). This lesson is quite similar to the last, just that we examine risk from the perspective of its investors.

Understanding Financial Risk

We have learned that a firm’s business risk is the risk associated with the firm’s operating income, of which sales risk and operating risks are components of it. In this lesson, we shift our focus to financial risk, which is the additional risk to a firm’s shareholders when a company uses debt financing.

When a company takes on debt, it takes on fixed expenses in the form of interest payments. The greater the proportion of debt in a firm’s capital structure, the greater the firm’s financial risk.

Degree of Financial Leverage (DFL)

We can quantify this risk in the same way we did for operating risk, looking at the sensitivity of the net income when operating income changes. This sensitivity is the degree of financial leverage (DFL), and is defined by the ratio of the percentage change in net income to the percentage change in operating income.

Formula:

DFL = EBIT / (EBIT – Interest Expense)

Like DOL, DFL is not a constant for the firm. In this case, it is dependent on the EBIT.

Financial Leverage and Shareholders’ Interests

So, what does all these mean for the firm and its shareholders? As implied by the formula, the higher the interest expense which is a fixed cost, the higher the degree of financial leverage. So while taking on more debt can potentially multiply the net income of the firm and shareholder wealth when sales are good, the leverage works both ways and can magnify losses when sales are bad. Therefore, the higher the financial leverage, the higher the risk to the shareholders.

However, higher risk can also come with the potential of higher returns to the shareholders. This is evident in the effect of financial leverage on the return on equity (ROE) of a firm.

The bottom line? Financial leverage increases the risk and potential returns to a company’s shareholders. A firm’s management should balance the need for the firm’s expansion through debt issuance, yet taking care of shareholders’ interests at the same time by not taking excessive risks. When a firm is unable to pay its debtors, default occurs, and the shareholders will not be very happy with the consequences!

Wrap Up

And that’s our quick lesson on DFL. We learned about the financial risk of a company, how to determine its degree of financial leverage, and the relationship between financial leverage and shareholders’ interests. Remember that it’s crucial for a firm’s management to balance the risk and potential returns to maximize shareholder value.

Up next, we learn how to compute the total leverage of a firm. See you again!