The financial risk a company faces results from its
financing decisions, for example, whether it chooses to borrow to finance its
investments or its operations. One way
to measure financial risk is through

*activity analysis*, specifically focusing on the impact of financing activities on profits. In this post, we focus on understanding the*Degree of Financial Leverage*, defined below, as a measure of risk. This is a companion to the post on the Degree of Operating Leverage (DOL).
A different measure of risk, beta, is based on stock
returns. It measures the sensitivity of
a stock’s return to the market as a whole.
In its pure form, it does not pay attention to fundamentals. However, people have developed the concept of
a “fundamental beta” which takes into account information such as operating and
financial risk. One argument in favor of
this approach is that beta typically is calculated using historical data, while
fundamentals provide information about the future performance of a firm.

**Financial Risk**

In this post, we consider financial risk estimated from a
firm’s fundamentals. There are two
popular approaches adopted in practice.
Both approaches share the objective of measuring financial leverage but
one adopts a balance sheet (i.e., stock approach) to the problem and the other
adopts an income statement (i.e., flow approach) to the problem. The

*stock approach*estimates financial leverage directly from the debt to equity ratio and the*flow approach*estimates financial leverage as an elasticity relative to Earnings Before Interest and Taxes (EBIT). This latter approach is referred to as Activity Analysis, and here, we describe how you use it to measure financial risk.
Financial risk in “Activity Analysis” is measured by the
“Degree of Financial Leverage.” The
ideas underlying this measure can be developed as follows. From the firm’s financial statements we can
first estimate a firm’s Earnings Before Interest and Taxes (EBIT) which
provides a measure of the operating performance for a firm. Similarly, if we subtract away Net Interest
Expense from EBIT then this yields Earnings Before Taxes (EBT). However, interest expense is tax deductible
and thus what is important for financial decisions in the real world is

*after-tax interest expense*. As a result, in practice the Degree of Financial Leverage (DFL) is defined and measured in terms of Earnings per share. That is, the usual definition is:
Degree of Financial
Leverage (DFL) = % Change in EPS/% Change in EBIT

This definition has the additional nice practical property
that it is in a form that provides an immediate linkage from Sales Revenue
forecasts to analyst earnings’ forecasts via the degree of total leverage. This is defined as follows:

Degree of Total Leverage
(DTL) = % Change in EPS/% Change in Sales = DFL * DOL

In the above the DOL is the Degree of Operating Leverage
which was introduced in a previous LESSON in this series.

In the lesson, you will learn how to calculate the DFL for
Wal-Mart and Intel. Then, you will
compare them to the betas, and see if a higher DFL is associated with a higher
beta. At the end of the lesson is an
exercise that lets you conduct a more systematic analysis of the relationship
between financial leverage and beta.

To access the lesson, from the FSA module, simply select it
from the Lessons menu: