Monday, November 19, 2012

Understanding the Degree of Financial Leverage

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:

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