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Financial Management and Strategic Management · Financing Decisions - Leverages

Financial Leverage and Degree of Financial Leverage (DFL)

Updated 4 October 2026 · Fact-checked

Financial leverage is the use of fixed-cost finance, such as debt interest and preference dividend, so that a change in EBIT causes a larger change in EPS. DFL = EBIT ÷ (EBIT − Interest − Preference dividend ÷ (1 − t)). Find EBIT, interest, preference dividend and tax rate, then substitute.

Understand Financial Leverage and Degree of Financial Leverage

A firm raises money by equity, debt or preference shares. Debt carries fixed interest. Preference shares carry a fixed dividend. These payments do not change when EBIT changes. This fixed burden is the source of financial leverage.

Think of it as a lever. EBIT moves up or down. Interest stays the same. So the profit left for equity holders moves by a larger percentage than EBIT. When EBIT rises, EPS rises faster. When EBIT falls, EPS falls faster. Leverage works both ways.

Degree of Financial Leverage (DFL) measures this. It is the percentage change in EPS for a 1% change in EBIT. If DFL is 2, a 10% rise in EBIT gives a 20% rise in EPS, and a 10% fall in EBIT gives a 20% fall in EPS.

Preference dividend is paid out of profit after tax. Interest is deducted before tax. So to compare them on the same footing, divide the preference dividend by (1 − t). This converts it to a pre-tax amount. That is why the DFL formula has the (1 − t) term.

DFL is 1 when there is no fixed financing cost. The more fixed financing cost relative to EBIT, the higher the DFL and the higher the financial risk. DFL is measured at a given level of EBIT. It changes if EBIT changes.

Key rules to remember

Degree of Financial Leverage (definition)
DFL = % change in EPS ÷ % change in EBIT
Use when the question gives two EPS and EBIT figures at different levels.
DFL with interest only
DFL = EBIT ÷ (EBIT − Interest) = EBIT ÷ EBT
EBT is earnings before tax. Use when there are no preference shares.
DFL with preference dividend
DFL = EBIT ÷ [EBIT − Interest − Preference dividend ÷ (1 − t)]
t is the tax rate as a decimal. Preference dividend is grossed up because it is paid after tax.
EPS
EPS = (EBIT − Interest) × (1 − t) − Preference dividend, all ÷ Number of equity shares
Interest is deducted before tax. Preference dividend is deducted after tax.
Financial leverage (ratio form)
Financial leverage = EBIT ÷ EBT
Same as the interest-only DFL. Some questions call this the financial leverage ratio.

How to solve Financial Leverage and Degree of Financial Leverage questions

Use this order for any DFL or financial leverage question. It handles interest, preference dividend and tax together.

  1. 1Write down EBIT. If the question gives sales, variable cost and fixed operating cost, compute EBIT first.
  2. 2Compute interest on all debt. Use the rate on each loan or debenture and its amount.
  3. 3Note the preference dividend, if any, and the tax rate.
  4. 4Gross up the preference dividend: divide it by (1 − t). Skip this if there is none.
  5. 5Compute the denominator: EBIT − Interest − grossed-up preference dividend.
  6. 6Compute DFL = EBIT ÷ denominator. Show the working.
  7. 7If asked for the change in EPS, multiply DFL by the % change in EBIT. State the direction too.
  8. 8Interpret in one line: what DFL means for risk and for EPS movement.

Quickest way: Fast DFL under time pressure

When to use it: Use for MCQs and for the first mark-earning lines of a written answer when EBIT, interest and preference dividend are given.

  1. Underline EBIT, interest, preference dividend and tax rate in the question.
  2. If there is a preference dividend, convert it first: dividend ÷ (1 − t).
  3. Subtract interest and the converted dividend from EBIT. This is your denominator.
  4. Divide EBIT by the denominator. In an MCQ, a DFL below 1 means you made an error. DFL is never below 1 when EBIT exceeds fixed charges.
  5. For a % change in EPS, multiply DFL by the % change in EBIT. No need to rebuild the full EPS statement.
  6. In a written answer, write the formula, the substituted values and a one-line conclusion. This earns the step marks.

Common mistakes in Financial Leverage and Degree of Financial Leverage

  • Subtracting the preference dividend directly from EBIT without grossing it up

    Students treat preference dividend like interest.

    Fix: Divide preference dividend by (1 − t) before subtracting. The dividend is paid after tax, interest before tax.

  • Using EBT or PAT in the numerator instead of EBIT

    Students confuse DFL with other ratios.

    Fix: The numerator is always EBIT. EBT appears only in the denominator, in the interest-only case.

  • Grossing up interest by (1 − t)

    Students over-apply the tax adjustment.

    Fix: Interest is already deducted before tax. Only the preference dividend is grossed up.

  • Forgetting interest on all debt sources

    Questions list debentures, term loans and bank loans separately.

    Fix: List each source with amount × rate and add them before computing DFL.

  • Applying DFL at the wrong EBIT level

    DFL changes when EBIT changes, but students reuse an old figure.

    Fix: Recompute DFL at the EBIT level the question asks about. Use the base EBIT for forecasting the change.

  • Stating that leverage always increases EPS

    Students remember only the upside.

    Fix: Say that leverage magnifies changes in both directions. A fall in EBIT causes a bigger fall in EPS.

Worked examples

Example 1

A company has EBIT of ₹10,00,000. It has 10% debentures of ₹20,00,000 and 1,00,000 equity shares. The tax rate is 25%. Calculate (a) DFL and (b) the EPS if EBIT rises by 20%.

Show the solution
  1. Interest = 10% × ₹20,00,000 = ₹2,00,000.
  2. EBT = ₹10,00,000 − ₹2,00,000 = ₹8,00,000.
  3. DFL = EBIT ÷ EBT = 10,00,000 ÷ 8,00,000 = 1.25.
  4. Current EPS = 8,00,000 × (1 − 0.25) ÷ 1,00,000 = 6,00,000 ÷ 1,00,000 = ₹6.
  5. Rise in EPS = 1.25 × 20% = 25%.
  6. New EPS = ₹6 × 1.25 = ₹7.50.
  7. Check: new EBIT = ₹12,00,000. EBT = ₹10,00,000. PAT = ₹7,50,000. EPS = ₹7.50. This matches.

Answer: DFL = 1.25. A 20% rise in EBIT raises EPS by 25%, from ₹6 to ₹7.50.

Example 2

A firm has EBIT of ₹12,00,000, interest of ₹2,00,000 and 8% preference share capital of ₹25,00,000. The tax rate is 20%. Calculate DFL and state the effect on EPS of a 10% fall in EBIT.

Show the solution
  1. Preference dividend = 8% × ₹25,00,000 = ₹2,00,000.
  2. Grossed-up preference dividend = 2,00,000 ÷ (1 − 0.20) = 2,00,000 ÷ 0.8 = ₹2,50,000.
  3. Denominator = 12,00,000 − 2,00,000 − 2,50,000 = ₹7,50,000.
  4. DFL = 12,00,000 ÷ 7,50,000 = 1.6.
  5. Fall in EPS = 1.6 × 10% = 16%.
  6. Check with numbers, taking 1,00,000 equity shares as an assumption: current PAT = 10,00,000 × 0.8 = 8,00,000. Less preference dividend 2,00,000 gives 6,00,000 for equity. New EBIT = 10,80,000. EBT = 8,80,000. PAT = 7,04,000. Less 2,00,000 = 5,04,000. Fall = 96,000 ÷ 6,00,000 = 16%. This matches.

Answer: DFL = 1.6. A 10% fall in EBIT reduces EPS by 16%.

Exam tips

  • Always check whether the question gives a preference dividend. It changes the formula, and examiners often include it.
  • Show the formula, the substitution and the answer. Step marks are awarded even if the final figure has an arithmetic slip.
  • When asked for the effect of an EBIT change on EPS, use DFL × % change. It saves time compared with rebuilding the EPS statement.
  • Write a one-line interpretation, such as higher DFL means higher financial risk. Interpretation lines often carry marks.
  • In MCQs, compute the denominator first. Most wrong options come from skipping the gross-up.

Practice questions from Financing Decisions - Leverages

Financial Leverage and Degree of Financial Leverage in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Financial Leverage and Degree of Financial Leverage: frequently asked questions

What is the DFL formula with preference dividend?

DFL = EBIT ÷ [EBIT − Interest − Preference dividend ÷ (1 − t)]. Here t is the tax rate as a decimal. The gross-up is needed because preference dividend is paid out of profit after tax.

Can DFL be less than 1?

When EBIT is above the fixed financing charges, DFL is at least 1. It equals 1 when there is no interest or preference dividend. If EBIT is below the fixed charges, the formula gives a negative or unusual value and the firm is in a loss position.

What is the relation between financial leverage, EBIT and EPS?

Fixed financing costs do not change with EBIT. So a given percentage change in EBIT leads to a larger percentage change in EPS. DFL measures how many times larger that change is.

Does a higher DFL mean higher risk?

Yes. A higher DFL means a larger share of EBIT is committed to fixed financing costs. EPS then falls sharply when EBIT falls, and the firm may struggle to meet interest on time.