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CA Intermediate · Financial Management and Strategic Management · Financing Decisions - Leverages

Which of the following correctly describes the Degree of Financial Leverage (DFL) of a firm at a given level of EBIT?

Degree of financial leverage is the percentage change in earnings per share divided by the percentage change in EBIT. It shows how sensitive shareholders' earnings are to operating profit because of fixed financing charges such as interest. The EBIT-to-sales relationship measures operating leverage instead.

  1. APercentage change in EBIT divided by percentage change in sales
  2. BPercentage change in EPS divided by percentage change in EBITCorrect
  3. CPercentage change in sales divided by percentage change in EPS
  4. DContribution divided by EBIT

Explanation

DFL measures the sensitivity of earnings per share to changes in EBIT, so it equals percentage change in EPS divided by percentage change in EBIT (equivalently EBIT/EBT). Option A describes operating leverage, option D is the formula for DOL, and option C is not a standard leverage measure.

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